One of the biggest problems for Australian investors is that they struggle to achieve adequate diversification if they confine themselves solely to Australian domiciled markets.
Like all investors, Australians show an inherent bias to their domestic market, where, for example with shares, they know the company they are investing into, and, they can use the tax-effectiveness of the franked dividends, and in addition, they don’t incur currency risk.
But Australian investors rub up against the problem that the local share market is one of the most concentrated in the world. The top twenty companies represent over half of the capitalisation of the market benchmark, the S&P/ASX 200 index. Four companies in the top 5 are the ‘big four” banks: financials make up about 35% of the index. This means that the movements (and returns) of the S&P/ASX 200 index are driven by the performance of a small number of large listed companies, in just a few industries – banking, mining, financial services, telecommunications and retail.
That is the crux of the argument of the importance that Australian investors to own international shares: to improve the diversification of their investment portfolio, because it gives them greater exposure to the global economy and to a range of industries and sectors industries that their home market simply does not have.
In particular, the technology boom in the US markets makes this need for diversification even more pressing. Australian investors have nothing like the breadth of exposures that their US counterparts have in stocks such as Facebook, Apple, Amazon, Netflix, Microsoft and Alphabet (the parent company of Google), to name just a few.
The bigger opportunities offshore
Apart from home-grown success story CSL, Australian investors do not have access to major pharmaceutical companies, the likes of Novartis, Pfizer, Roche, Sanofi, Merck & Co., Johnson & Johnson and GlaxoSmithKline. Nor can they share in the revenue streams of global consumer goods companies like Nestlé, Procter & Gamble, Unilever, PepsiCo, LVMH (Louis Vuitton Moët Hennessy), L’Oreal, Anheuser-Busch InBev, Nike and Colgate-Palmolive.
Australian investors increasingly understand the need for overseas diversification. According to the Australian Securities Exchange (ASX) Australian Investor Study 2017, ownership of international shares has increased. Where 5% of the adult population said in 2014 that they directly held shares listed on an international financial exchange, that proportion is now nearly 8%.
Australian investors also had $471 billion invested in global managed share funds at June 2017, an amount that doubled between 2009 and 2016. And there is $8.5 billion in global listed investment companies (LICs) on the ASX, and the same amount in global exchange-traded funds (ETFs).
For many Australian share investors, what puts them off global shares is being exposed to exchange-rate movements – currency risk.
Foreign exchange volatility can substantially alter profits and losses on international shares. If you make a capital gain on foreign shares, what matters is what happens when you convert your profit to Australian dollars.
The added risk of currency movement
The currency risk posed by the Australian dollar must always be factored into the decision to invest money overseas. But while the volatile Australian dollar can potentially slash any gains made, it can also increase them, in the right circumstances.
In essence, the currency effect on overseas investments can go one of many ways, increasing the risk of simply buying an overseas stock.
Say you have made a capital gain on some foreign shares. If the Australian dollar falls against the currency in which the shares are quoted, your capital gain increases. But if the Australian dollar strengthens against the foreign currency where your investment is domiciled, your capital gain is less.
Conversely, if your overseas shares fall in price, you hope that the foreign currency in which the shares are quoted rises against the Australian dollar, to offset some of your capital loss. But if the share price falls and the foreign currency weakens against the Australian dollar, you will face a ‘double-whammy’ loss: where the rise of the Australian dollar worsens your loss on the investment.
For example, imagine you bought 100 Facebook shares on the first trading day this year (January 2), with the share price at $US123.41. The purchase cost $US12,341, which, with the Australian dollar buying 73 US cents at the time, cost you $A16,905.
Your Facebook shares are now trading at $179.04, for a nice gain of 45%. Unfortunately for you, the Australian dollar has gained 3 cents, to 76 US cents. In Australian dollar terms, your shares are now worth $23,557, for a capital gain of 39%. The strengthening Australian dollar has eroded your return.
What would have been better for you would have been the positive double whammy of appreciating shares, and weakening Australian dollar. Say the Australian dollar was now at 65 US cents: your Facebook shares would now be worth $27,544, for an Australian dollar capital gain of 63%.
Not everyone wants to hedge
Some professional investors do not mind taking currency risk – they view it as another layer of diversification. This line of thinking goes that the long-term capital gains on the shares they buy should more than compensate for currency fluctuations.
But for retail/SMSF investors, it is a scary thought that the Australian dollar has moved from $US1.08 (when it was floated in December 1983), to a low of 47.75 US cents in April 2001, back to parity with the US dollar again in October 2010, to a record high of $US1.10 in July 2011, and back to 76 cents. Our dollar is a volatile currency, and this can have a significant impact on returns from overseas investments.
Some professional investors get around this uncertainty by hedging their overseas share exposure back into Australian dollar, by locking in a known rate of currency exchange for their investment gains, so that they pick up only the movements in the overseas shares, in the local currency.
Other ways to hedge your currency risk
Retail investors/SMSFs can profit from currency movements by using contracts for difference (CFDs), margin FX, options and futures contracts (standard and mini-sized), all of which offer leveraged exposure to exchange rate movements, where you pay interest on a long position and receive interest on a short position.
Also, currency MINI warrants traded on the ASX allow traders to take a leveraged position on the Australian dollar rising or falling against the range of currencies: Citi has a series of long and short MINIs over the $A/$US, $A/pound, $A/euro, $A/yen and $A/$NZ rates.
Another option for investors is using traditional managed funds that have currency hedging strategies built in, or by using currency exchange-traded funds (ETFs), which trade on the ASX.
The US Dollar ETF from ETF issuer BetaShares (ASX code: USD) provides simple, low-cost exposure to the performance of the US dollar relative to the Australian dollar. If the US dollar rises by 10% against the Australian, the USD ETF is designed to go up 10% too, before fees and expenses. Conversely, US dollar will go down if the US dollar falls against the Australian dollar.
BetaShares also has a ‘Strong’ Australian Dollar ETF (AUDS), which magnifies exposure to the Australian dollar versus the US dollar: a 1% increase in the value of the Australian dollar relative to the US dollar on a given day can generally be expected to deliver a 2%–2.75% increase in the value of AUDS (and vice versa). As well, the issuer has listed on the ASX a ‘Strong’ US Dollar ETF (YANK), which offers magnified “long” exposure to the $A/$US cross, on the other side: if the US dollar gains by 1% on a given day, it can generally be expected to result in a 2%–2.75% increase in the value of YANK (and vice versa).
BetaShares also has a British pound ETF (POU) and a Euro ETF (EEU). ETF issuer ETF Securities has ASX-listed ETFs over the US dollar (ZUSD) and the Chinese renminbi (literally, ‘people’s currency’), with a stock code ZCNH.
While these are essentially vehicles for short-term currency trading, retail investors trying to hedge their overseas investments can use them all. With an overseas share investment, you are essentially looking to have an equivalent ‘short’ (that is, you have sold) exposure to the currency in which your shares are denominated. You don’t want the foreign currency to fall relative to the A$ while you hold the shares, so you establish a short currency position that protects you while you hold the shares.
Information current as at 14 December 2017. This document has been created by Westpac Financial Services Limited (ABN 20 000 241 127, AFSL 233716). This This article provides an overview or summary only and it should not be considered a comprehensive statement on any matter or relied upon as such. This information does not take into account your personal objectives, financial situation or needs and so you should consider its appropriateness, having regard to your personal objectives, financial situation and needs having regard to these factors before acting on it. This article may contain material provided by third parties derived from sources believed to be accurate at its issue date. While such material is published with necessary permission, no company in the Westpac Group accepts any responsibility for the accuracy or completeness of, or endorses any such material. Except where contrary to law, we intend by this notice to exclude liability for this material. Westpac Financial Services Limited and some of its related entities may have invested in the past, currently or in the future, in some of the ETFs referred to in this document. ©Westpac Financial Services Ltd 2017
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