AFR ETF series: exchange rates

Australian Financial Review, Smart Money, June 2011

You’ll have heard about the climb in the gold price to record levels. But if you’d invested in the main exchange-traded fund that tracks gold, offered by ETF Securities, you might well wonder whether that climb really happened. While ETF Securities’ web site shows that gold is up 34.28% in the last year, if you’d bought its gold ETF 12 months ago you’d actually have gone backwards and be down on your investment.

The fund’s done nothing wrong: it tracks the performance of its underlying metal loyally. But it does so in US dollars, the main currency in which gold is traded. And that’s the problem: the Australian dollar has risen so dramatically against the greenback that any gains from gold, or indeed any strongly performing US dollar-based asset, have been wiped out.

In late 2008, one US dollar would buy you over A$1.60. Today, it gets you about 90 Aussie cents. That extraordinary turnaround, a near doubling (or halving, depending on your perspective) in two and a half years, has obliterated unhedged overseas exposures for Australian investors, be they shares, funds, bonds, property or the currencies themselves.

ETFs have been among the products that have struggled, in performance terms at least. But providers with offshore products now report a sense that the Aussie dollar has become so strong, and the US dollar so weak, that we must be near a reversal – in which case, everything changes.

“Business is good,” says Tom Keenan of iShares, which is the provider most exposed to movements in the currency as it offers 19 ETFs that invest in overseas markets. “The funds we’ve got in those have grown by 50% since the Aussie dollar hit parity in October. Australian investors are starting to recognise that diversification into global equities is potentially going to pay off more in the future than it did in the last decade. The Australian market has done very well and investors have been generally underweight global equities, but now a lot of our clients are saying the Aussie dollar is at such a high level relative to its long term averages that an unhedged position in global equities might make a lot of sense.”

For a reversal in the exchange rate to take place, one needs to be a believer in a US recovery and global growth, but it seems that many believe it’s only a matter of time until that happens.

But the soaring Aussie dollar has triggered another pattern: the beginning of hedged ETFs. So far only one has been launched, by BetaShares, which offers a hedged gold bullion product. “Investors want to decouple the currency from the asset class decision,” says Drew Corbett at BetaShares. “The nature of the fact that existing products are unhedged means you have to take a view on the currency as well, so by hedging those currency fluctuations out, you can make a decision based on the underlying assets. Most people are looking for exposure to outright movements in the gold price, and have been extremely frustrated by the fact that the Australian dollar has completely eroded those returns.” If you believe the US dollar is due to strengthen against the Australian, then you would miss out on those gains in this product and would be better off in the ETF Securities one; the hedged product suits those who either think the US dollar has further to fall or don’t want to have to think about that in the first place.

BetaShares also launched a currency ETF, Australia’s first, which provides access to the US dollar through a fund. At some point, this will pay dividends based on interest earned on the US dollars, although since US dollars aren’t currently paying any meaningful interest, it will be a while before that happens. Corbett says the product is “for those who have a view that there is a value play in the US dollar:  a play on the eventual recovery in the US economy.” It’s also for investors who want to diversify assets outside Australia while their own currency is strong, and potentially for them to hedge other investments.

While the time for hedging has arguably passed, it would be no surprise to see more hedged products launched in Australia, just as many Australia-based global managed funds offer hedged and unhedged versions. “We’re constantly reviewing new product opportunities and investor demand, and hedged equity exposure is certainly something we might look to provide in the future,” says Keenan.