The fear of wild currency swings often deters people from investing overseas. But if you’re investing in countries with relatively stable currencies, and you’re a genuine long-term stock investor, then currency fluctuations will probably wash out over the course of a business cycle.
If that’s the case, your returns will mirror those of the shares you purchase. The point is to worry more about the businesses you or your fund manager buys than about the currency.
In the Peters MacGregor Global Fund, we can hedge currency risk, but we typically do so only when currency rates threaten to cause major losses to the portfolio. We hedged against falls in the Australian dollar a few years back when it was around parity with the US dollar, for example, and currently we have hedged our exposure to the Chinese yuan.
We own Chinese technology companies Tencent, which is the owner of the WeChat messaging service, Baidu, China’s answer to Google (now Alphabet), and JD.com, commonly referred to as the Amazon of China, although there are major differences.
The tailwinds blowing behind these businesses are huge and they dominate their markets, but we don’t want a major one-off devaluation of the Chinese yuan to affect our portfolio. As China’s debt increases and growth slows, there’s a high risk that a devaluation could be used to stimulate the economy.
The point is that we don’t hedge often. Over the years, each time I’ve read the results from a fund manager’s review of their hedging, they lament the time and cost of hedging that hasn’t helped their results. I’m sure there are exceptions, but history is littered with the carcasses of businesses and investors that bet wrong on currencies, which is why we consider it only as a form of protection.
The Australian dollar is currently around its historical average against the US dollar. With debt levels reaching unprecedented levels in China and Australia, at some point, investors will be glad they have some overseas currency exposure to mitigate poor returns from a lopsided portfolio of highly leveraged, cyclical banks, resources companies and direct and indirect property holdings.
It’s important to remember that in a serious downturn, the correlation of most assets becomes one (i.e., they all move in the same direction), so currency diversification remains one of the easier ways for investors to reliably diversify their portfolios.
With only 1 per cent to 2 per cent of self-managed superannuation fund assets reportedly invested abroad, it’s a good time to review your currency exposure while the Australian dollar is at or above historical averages against the major currencies.
Risky means of diversification
Both the numbers and my recent conversations with investors suggest the average Australian currently has too many eggs in one basket. After an epic 25 years of strong property prices that have stimulated huge returns and dividends from the big banks, the focus should now be on how much more debt we can handle before the cycle switches into reverse.
How would your portfolio perform if Australian stock and property prices fell, dividends were cut and the Aussie dollar fell substantially to stimulate exports and attract the foreign investment needed to support our banks? Some of these falls would probably be more permanent than temporary.
Unfortunately, too many words have been spilt recently recommending risky solutions to these fears, such as buying passive products such as index funds and ETFs based on a broad index of US shares.
The US sharemarket is likely the most overvalued currently, due to stocks such as McDonald’s. Despite its earnings being stuck at 2009 levels, its price-to-earnings ratio has more than doubled, from 13 to 27. Why would anyone pay nearly 30 times earnings for a company that isn’t growing?
Most people wouldn’t, which is why passive funds are probably behind the move. They pay no attention to value but, as Warren Buffett warns, eventually value matters. McDonald’s isn’t an orphan either; there are scores if not hundreds of expensive companies like this that people own unknowingly through ETFs and index funds. This is a good example of the limitations of diversification; more is not always better.
What’s worse is that there are no natural buyers for stocks that ETFs will be selling en masse during the next downturn as, unlike a closed fund such as a listed investment company, ETFs expand and shrink as demand fluctuates for their units. This ‘feature’ doesn’t seem well understood by those at most risk from falling share prices.
Right now, volatility is at an all-time low and markets are calm. This won’t last forever, so now’s the time to review your foreign currency exposure (most Australians have hardly any, leaving them vulnerable to a local recession), what assets you own and why, and to consider what strategies will perform over the next decade. For Australia at least, this coming period promises to be much more difficult than the goldilocks 25 years we’ve recently enjoyed.
Nathan Bell is head of research at Peters MacGregor Capital Management. For information about investing in our actively managed global portfolio, visit https://petersmacgregor.com.
Disclosure: Peters MacGregor Capital Management Limited holds a financial interest in Baidu, JD.com and Tencent, through various mandates in which it acts as investment manager.