Smart Investor: Making the best of the soaring Aussie dollar

Smart Investor, July 2011

From an Australian’s perspective, forex markets haven’t looked like this in living memory. At the time of writing, your Australian dollar buys you almost US$1.10, and £0.65p. It makes a skiing trip in Colorado or a spell in England visiting family newly affordable. The days of the Barmy Army turning up at the MCG and singing “we get three dollars to the pound” are well and truly behind us.

All of which is very refreshing for globetrotting Australian holidaymakers, if not our exporters. But what does it mean as an investment class? How does one take a view on the currency and get on the right side of it?

SUBHEAD: FOREX PLATFORMS

Firstly, the well-branded forex websites like OzForex are not intended as ways to play the market. They do, though, offer an interesting service.

OzForex was launched by a powerful group of backers including Macquarie Bank and the Carlyle Group in 1998, and includes similar platforms in the UK, Canada and New Zealand, among other places; these days the group has over 100,000 users and offers 52 different currency pairs. But it exists to help people transfer money at reasonable rates, rather than to make a killing on currency movements. “Our founder  built the web site as an information source; the first clients to use it for transactions were migrants moving funds between their own bank accounts and high net worth individuals purchasing property around the world,” says Jim Vrondas, head of client dealing. “People might have sold a property in the UK and needed to convert the pounds into Australian dollars; or they had bought property in the UK and needed to town Aussie dollars into pounds to pay for it.”

While a site like this is chiefly functional, it does of course allow you to buy a foreign currency you think will go up in value. You could do this through your bank too: many banks (particularly international ones like Citigroup and HSBC) allow you to set up multi-currency accounts and make transfers between them. But the rates are rarely favourable through banks, and one of the main points of a site like Ozforex is that you make much better savings. “Typically an individual may be saving 1 to 2% on the rate itself, and there is also a saving on the fees,” says Vrondas, who says there is no fee on any transaction of over A$10,000. Sites like these also offer 24 hour operation.

SUBHEAD: GETTING HEDGED

You can also use sites like these for hedging. This is an increasingly important point. Let’s say you bought a mutual fund investing in US shares, and it went up 30% in value. That’s great – but if the Australian dollar also went up 30% in value against the US dollar, then it will have wiped out your losses and you will have come out flat. Worse happened for investors in global equity mutual funds when not only did the Aussie dollar strengthen enormously, but global markets went down too. This is one of the reasons that Australian stock markets have, from the perspective of the Australian investor, comfortable outperformed global markets over the last decade.

Hedging is a method of taking forex movements out of the picture. Many mutual funds offer a choice of a hedged or an unhedged version, or they will have a stated hedging policy (often attempting to take, say, half of the currency exposure out). But you can do it individually too. “Someone who has invested in shares in the US and at some point plans to bring them back to Australia is wearing a currency risk,” Vrondas says. “That could wipe out any gains they’ve made. We can provide tools to protect against that.”

Foreign exchange platforms provide a spot rate – the exchange rate right now – or forward rates, which set a particular conversion price for various points in the future. By entering into a forward exchange contract to lock in a rate, say 12 months from now, the investor can be protected against exchange rate moves against them. There is, though, a disadvantage in hedging, apart from the modest cost: if you hedge and the Australian dollar starts moving in the other direction, then you’ve missed out on a gain.

SUBHEAD: LEVERAGE WITH CFDs

Forex is not an easy business to predict for an investor. If you think predicting where a share price is going to go to is difficult, imagine the variables influencing the movement of a currency: global politics, economics, the local factors affecting every other currency the Australian dollar is measured against. “In studies we’ve found the majority of people lose money trading FX,” says Vrondas. “It’s not something we do and we don’t promote it.” He has previously worked in an investment bank where part of his role was to speculate on currencies and proprietary trade them. “In order to be successful it does take a very strong discipline and personality type to do it well.”

For those who do want to take a more active position on the currency, the obvious way to do it now is through contracts for difference. These offer investments over a host of different asset classes – local and global shares, bonds, commodities – and currencies are very much in the mix. David Land at CMC Markets says that foreign exchange and index CFS are the two most popular areas on his platform in Australia. And Chris Weston at IG Markets says trading the Australian dollar is the single highest-volume product that platform offers.

CFDs allow you to leverage – and of all the products available on CFD platforms, currencies offer the greatest degree of that leverage. At both CMC Markets and IG Markets, the margin required is typically just 1%: that means for $1 of commitment, you get $100 of exposure. For $100 of commitment, you get $10,000 of exposure.

Clearly, this magnifies risk as much as reward: You can make 100 times your money, and you can lose that much too. “Make no mistake, currency trading does carry a high degree of leverage,” says Weston. “You need to understand that you can both make and lose a lot of money if you don’t know what you’re doing.”

That said, providers do point out that FX tends to move in a different way to shares. “The standard quotation mechanism for foreign exchange is to four decimal places,” says Land. “So for someone trading $10,000 – the industry standard minimum trade size – that works out as $1 per tick movement. That’s why the margin on FX is so low: if it was high it would become very expensive, in terms of overall margin, to trade it.” He adds: “The more liquid the product and the longer the hours it trades, the lower the margin will be. FX markets are the most liquid.”

In practice, how do investors use the FX facility on CFDs? “There’s a real spectrum of people who trade FX,” Land says. “A lot of people view FX as being a short-term market for intra-day traders, that’s the popular opinion of it. But there’s a growing element of people who are keen to trade it as a position – not necessarily the same length of time as a share CFD, but not that much different.” This makes more sense for people who have a long term view on a currency and are prepared to wait to be right. “FX provides big trend moves over an extended period of time,” says Land. “People are getting more keen on capturing those moves with FX.” But, with the vast majority of trading taking place against five major currencies (US dollar, euro, sterling, Swiss franc and yen), Land points out: “Someone who is looking to capture big trending moves may have to wait a fair while between drinks for the right set-up.”

Weston, though, says “CFD traders by their nature aren’t particularly long traders, and currency in particular is usually only a couple of days.” But he adds: “The bulk of FX is a technically-oriented market, because there are so many different working parts. A lot of currency traders use technical analysis.” That puts it into the realm of people who enjoy using charting strategies for their share investments.

On platforms like these, the Australian dollar/US dollar cross is by far the most active for Australian investors, followed by other Australian dollar pairs such as yen, sterling and New Zealand dollar. “People like trading the Australian dollar because they have a relationship with it,” says Weston. “They use it every day. People understand how it moves, how interest rates will affect it, how commodities will move it.”

And where is the currency going? That’s a (more than) million dollar question. “We’re not sure how long the gains will last and when the A$ will retrace,” says Corbett. “At $1 we weren’t sure it could go much higher. Now it’s at $1.08 and some are still saying there’s room for it to get stronger.” Analysts are divided but most expect continued strength for a while yet. “Unless the global economy slides back into recession, which appears unlikely, the A$ is likely to average above parity over the next few years on the back of strong commodity prices and relatively high Australian interest rates,” says Shane Oliver, chief economist at AMP Capital Investors. “Expect US$1.10 by year end.”

BREAKOUT: CURRENCY ETFs

Another example of currency entering the investment mainstream came with the launch of Australia’s first currency exchange-traded fund (ETF) by BetaShares. ETFs can be bought and sold like any other share on the ASX, and this one gives exposure to US dollars.

Launched on February 1, it’s a simple premise: the ETF holds US dollars in a bank account with JP Morgan Chase Bank. When BetaShares receives demand, it purchases US dollars at the swap rate and passes them on to the bank account, and creates new units in the fund based on the value of the dollars it has put in.

In the short term, this is a play on the idea that the Australian dollar surely can’t get much stronger against the US, and must eventually fade. If it does, the ETF should go up in value by a corresponding amount: if the US$ goes up 10% relative to the A$, the price of the ETF should go up 10% too.

Longer term, the interest the dollars earn will be set off against the management fee, or even to provide dividends. That’s not going to happen any time soon: the US interest rate is close to zero and will remain so until the US economy is clearly improving. But it’s a potential gain in the future.

“For those who have a view that there is a value play in the US dollar – a play on the eventual recovery of the US economy – that’s one of the core reasons investors have entered the transaction,” says Drew Corbett, head of investment strategy and distribution at BetaShares. “Others simply want to diversify outside the Australian dollar at these much higher levels; they may be considering purchasing assets offshore in the future and wish to lock in the gains in the currency. So a high net worth individual considering buying property in the States may not want to buy property right now, but will want to lock in the exchange rate today.” He says that many Australians also have a heavy weighting to resources in the portfolios, for which US dollar holdings will serve as a hedge if those stocks start to decline.

Why an ETF for currency exposure? “You don’t have to set up an account, transfer money, or take the risk of CFD issuers,” Corbett says. “It’s not leveraged, and not adding additional risks of margin calls and the like affecting your position.” Correspondingly it’s low-risk and not for everyone. “For a hardcore FX trader who wants leverage, we wouldn’t expect them to choose this over one of those avenues,” Corbett says.