Does a strong Aussie dollar mean we should invest offshore?

Australian Financial Review, Smart Money, December 2010

Everyone knows that when the Aussie dollar’s strong, it’s a good time to buy things from overseas: cars, clothes, foreign holidays. But should the same logic apply to investments? If your dollar will buy more foreign stocks today than it used to, is that a good reason for diversifying your holdings overseas?

There are a few questions to answer in making that decision. Among them: where do you think the currency’s going next? What are the merits of overseas shares versus Australian in the near term? And do you want a fund that exposes you to movements in the currency, or hedges them out?

“Given the strength of the currency, we think it’s not a bad time for Australian dollar-based investors here to broaden the scope of their investment,” says Roy Chen at GVI, which runs an international equities fund from Australia. “We always argue that investors should diversify their portfolio. When your economy is doing well and the currency is high it’s difficult to persuade investors to go offshore. But that’s the best time.”

GVI recently launched an unhedged version of its international fund, which has run in a hedged form for six years. “We wanted to give investors a choice,” Chen says. “Investors may have their own view on where the A$ may be heading, so launching an unhedged version allows people to invest in line with that view.”

But where is the Aussie dollar going? It is at a level of unprecedented strength. When it moved above parity against the US dollar in October – that is, one Australian dollar being more than one US dollar – it was the first time in 28 years it had done so. It has risen so high partly on the strength of the Australian economy, partly because of foreign demand (particularly from China) for Australian commodities, and partly because of weakness in the economies whose currencies it is most frequently compared to – the USA, the euro zone, the UK and Japan.

Some feel that the Aussie can’t possibly stay that high, and that at some point the US economy will recover and we will move back to an exchange rate of the level we’ve been more familiar with in recent years. Under this scenario, it’s a great time to buy international assets, since if the Aussie dollar does fall again then your overseas holdings will increase in value in A$ terms. “It certainly would be a pretty decent idea allocating more to overseas stocks if you have a three to five year time horizon,” says Ben Potter at IG Markets. “In the short term you could continue to see the Aussie strengthen more, but on a five year basis you would be a bit more confident it is going to retreat to its normal range as the US gets back on its feet.”

The problem is, not everyone thinks that way; in fact, some believe it may go higher. “While the A$ is vulnerable to a correction, having risen so fast since late August,” says Shane Oliver at AMP Capital Investors, “unless the global economy tanks again it is likely to average above parity over the next few years on the back of strong commodity prices and the relative strength of the Australian economy.” Oliver thinks the likely level is “probably around US$1.10.” Under that scenario, investing in international shares, unhedged, is a risky position to take because further gains in the Aussie dollar against the greenback will erode your investment returns.

Of course, investors don’t have to take currency risk when they buy overseas shares. Many fund managers offer both hedged and unhedged versions of their global funds; hedged options available in Australia include products from BT, BlackRock, GMO, MFS, MLC, Macquarie, Martin Currie, Schroder and Zurich, plus index funds from State Street, Russell and Vanguard. These neutralise movements in the currency.

Also, few people make share investment decisions based purely on currency movements. “You assess the quality of places to invest based on their growth outlooks,” says Potter. “Any currency factor should be a secondary thing, a bit of cream on the top. It’s like, you don’t necessarily base a business decision on taxation.”

If that’s your view, the question becomes about the relative merits of global and Australian shares, and the benefits of diversification. The effect of a strong currency on domestic shares is difficult to call: on one hand, for any company that exports, it erodes profits and it makes it much harder for that company to compete with global peers. On the other hand, a strong currency normally means a strong economy, with cashed up companies and consumers, which supports corporate growth and hence the share market.

Naturally, there are a range of different outlooks overseas depending on where one is looking. Europe is not in a great way right now and the US is some distance from recovery. That said, a contrarian investor would say those are therefore the places to invest, ahead of inevitable improvements when they come. “A lot of people are saying US equities are representing a once in a long time buying opportunity,” says Potter. “There’s a big earnings recovery happening there, companies are deleveraged significantly and there is only upside from the consumer side.” That said, he’s still not sure it’s a better prospect that Australia’s own commodity-fuelled momentum. “It would be hard to say US growth will outstrip the commodity side of things.”

The increasingly widespread view is that emerging markets are the engines of global growth at the moment; others are more specific and say Asia. “The Asia story is 60% of the world’s population reclaiming their share of wealth – getting back to where they have been for 18 of the last 20 centuries,” says Kerry Series, chief investment officer of 8 Investment Partners, a new Asia-focused Sydney-based manager backed by the South African financial services group Sanlam. “There will be 300 million more workers in Asia in the next 10 years. The labour force in developing countries will shrink over the same period.” His Asia Pacific Partners Fund takes a high-conviction approach to Asian stocks.

Others see the same opportunity but play it in a different way. The GVI fund, for example, is a developed markets product, but since that definition includes Hong Kong and Singapore is can invest in many stocks with exposure to emerging markets without physically being based in them: Hutchison Whampoa or Swire Pacific, for example, as well as European companies like Siemens with heavy involvement in Asia.

Still, investors don’t have to choose just one market; a sensible approach is to diversify, and the buying power of a strong currency does mean you can purchase a lot of exposure to foreign markets for less money than before.

BOX: The risks of going offshore

Overseas investment has a lot to recommend it: exposure to different growth stories, diversification, and the ability to get exposure to sectors that aren’t really represented in Australia, like pharmaceuticals or automotive manufacturers. But it comes with risks too.

One is familiarity. Investors in Australian large cap companies have generally built an informed decision about the companies, because they interact with them every day, whether through buying an insurance policy, drinking a particular beer, going to the bank or shopping in a mall. They are very unlikely to have that degree of familiarity, and hence a decent judgment on product quality, about foreign companies. If investing through mutual funds, that doesn’t really matter so much: you’re paying someone else to make that view. But certainly for anyone investing directly, it can be a challenge.

The risk of currency movement, both positive and negative, is discussed in the main article, but there are other elements of difference too. In much of the world, such as the US, the culture of paying high dividends is much less entrenched than in Australia. So investors who like their regular yield inflow may find themselves disappointed by their returns from overseas.

Those who have been attracted by emerging markets should realise they are taking a risk. The chances of greater returns are improved, because these are companies and economies very much on an upward path. But at the same time, the risks of losses are higher too: governance standards at companies may vary, their local markets may be volatile, and the path is unlikely to be as smooth as in a developed market, for better or worse.

For these and other reasons, Australians usually trust fund managers to do their international investing, even if they tend to do their Australian share shopping directly through a broker. How much to put overseas is a question with no right answer – but by way of guidance, a balanced option super fund will often have about 20% of its assets in international shares. For example, that’s the case at AustralianSuper’s balanced option right now, compared to 34% Australian shares; its mandate allows it to put between 10 and 40% into international shares.