News & Commentary

Helm April 2010: To hedge or not to hedge? 14 Apr 10

• To hedge or not to hedge
• Editor''s letter
• Recovery on course, despite GFC mark II
• Your say
• Vanguard''s new Index Chart

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To hedge or not to hedge currency exposures

by Paul Chin, Senior Manager, Research & Technical Services

Investors choosing to diversify their portfolios by taking on overseas holdings face the issue of whether to hedge their foreign exchange exposures. Where owning domestic assets provide solely that investment’s return stream, owning overseas assets assumes currency impacts as well. The potential for high volatility in the Australian Dollar (AUD) can have a resultant effect on portfolio balances, especially over shorter time frames. In fact, as recently as 2008, the AUD relative to the US Dollar (USD) lost in excess of 37 per cent during a turbulent three-month period to October 2008, only to recover some 50 per cent in the six months from February 2009.

Currency hedging – an effective tool
Currency hedging can assist in managing risk by attempting to remove the effects of foreign exchange market (FX) fluctuations and, in doing so, leaving only the given asset class’ return. For instance, in a simplified hedged investment scenario (ignoring forward premium/discount dynamics), a 10 per cent equity return in USD terms remains a 10 per cent outcome for an Australian investor, all things being equal. Without currency hedging, that same 10 per cent equity return could be negated or boosted by a rise or fall in the AUD-USD.

For defensive assets like international fixed interest, hedging is a critical tool to isolate the asset class return without having currency effects swamping net returns; for growth-oriented assets – including international REITs and equities, hedging may be of lesser importance.

Over longer time periods FX exposures are likely to have a negligible effect on overall investment returns, with losses and gains historically cancelling each other out. However, currency volatility can be painful for investors over intermediate periods and can compromise a portfolio’s ability to meet underlying
obligations, such as spending policies or income. Unmanaged currency exposure can therefore represent an uncompensated risk, especially for investors with shorter-term investment horizons such as retirees.

How much risk can you stomach?
Investors with a high risk appetite may be able to handle a fully unhedged position. Underpinning their beliefs may be that, “currencies are lowly correlated with my underlying assets and will therefore provide a source of further diversification to my portfolio”. Investors should be aware that the international asset’s returns could be completely nullified by associated FX volatility. Such investors would accept the full brunt of currency movements – which can move quickly and dramatically as highlighted earlier.

In contrast, a highly risk averse investor may prefer to eliminate the additional currency return volatility – and receive the asset class return by itself. A compromise between these two strategies is a 50 per cent hedged position, perhaps best described as the position of least regret.

Conclusion
As this article is being written, the AUD sits strongly relative to most major currencies. Given its present position of strength, there may be a temptation to take a view on currency, however, a number of academic studies have supported the notion that foreign exchange is inherently difficult to forecast over periods of days or even weeks and tend to be clouded by the noise of news and events. Decisions to hedge (or not) should therefore not be taken lightly.

Before making an investment decision, you should consider your circumstances and consult your financial adviser on whether this information is applicable to your situation.

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Editor''s Letter

by Robin Bowerman, Principal and Head of Retail

Investing would be so much simpler if it was just a matter of applying scientific analysis to our investment approach. That sort of analysis suggests a high level of certainty – a right and wrong way to proceed. Sadly, despite an entire investment industry’s best attempts, there will always be a level of uncertainty. Life’s like that.

That is not to say that economic and market analysis are not both important. An important part of Vanguard’s investment approach is an acceptance that investing is part science and part art. And with the acceptance that not everything can be measured and analysed comes a sense of humility.

Vanguard’s global Chief Economist, Joe Davis, recently visited Australia and shared some of the latest thinking and analysis out of the investment strategy group that he heads.

A key discussion point was around the outlook for global economic growth – in particular the difference between the developed world and emerging markets. While consensus economic forecasts suggest subdued economic growth in the world’s developed economies compared to emerging markets like China and India it is interesting to reflect on what that may – or may not – imply for investment returns and asset allocation.

There is a critical question for investors looking at economic forecast data. What is the link between forecast economic growth and future stockmarket returns? This is where science is both helpful and potentially misleading.

The economic forecasts are real enough. However, what Vanguard analysis suggests is that the link between global GDP growth forecasts and future stock market returns is negligible to non-existent. Looking back over more than100 years of data Joe Davis says the correlation between a country’s’ forecast economic growth and the sharemarket returns that markets then delivered is zero. So switching asset allocations from (say) developed economies to emerging markets may not be rewarded in line with economic expectations.

The global financial crisis proved one thing conclusively – we live in a highly connected and interrelated global marketplace. Many companies that are well placed to benefit from growth in emerging markets are likely to be multinational companies based in the developed world. Those companies – and in particular their shareholders – are putting capital at risk to develop their businesses in new markets so naturally they will have a legitimate call on the profits and capital growth generated.

So perhaps the message for investors when it comes to capturing investment market returns look beyond economic growth forecasts and do not be too quick to write off the developed world.

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Recovery on course, despite GFC mark II

by James Dunn*

As the world struggles its way out of the global financial crisis (GFC), it is at risk of GFC mark II: the Global Fiscal Crisis. Vanguard’s chief economist, Joe Davis, told the firm’s 2010 Australian roadshow, held in March, that a fiscal crisis – with governments losing control of the public finances – was a potential legacy of the financial crisis, with the national balance sheets of several developed nations (most notably Portugal, Ireland, Italy, Greece and Spain, the so-called PIIGS) in disarray and sovereign debt (that is, government bond) markets in turmoil.

Debt levels for the USA, UK and Eurozone countries have risen sharply since late 2007, when they were forced collectively to commit trillions of dollars in stimulus packages and bank bailouts. Davis said the debt levels of these nations – and Japan, which already had high debt levels before the GFC because of its ageing population and falling tax revenues – were unsustainable, and investors were right to be concerned about them. In particular, the high debt and the jobless rate in the world’s largest economy, the US, were worrisome. Like the other major economies, the US is faced with the dilemma of what happens as the massive government stimulus put in place since 2007 to fight off recession – and which has cost more than the nation spent in World War II – is withdrawn, with the big question being: is there enough real demand in the economy for recovery to be sustained?

Putting the US “jobless recovery” firmly in an Australian context, Davis said that the US had lost about 8 million jobs in the recession: or the equivalent of the populations of Sydney, Melbourne and Brisbane. But Davis presented a firmly optimistic view, reiterating Vanguard’s view that the global economy’s recovery will be self-sustaining in the near-term – despite the obvious risks.

While the sovereign debt issues in Europe and the question of how the world will manage the scaling back of global fiscal stimulus were potential negatives that cannot be ignored, Davis said that on the plus side factors such as strong performance in the global trade, manufacturing and technology sectors, which were still at a favourable stage in the inventory cycle could be counted.

For Australia, Davis was particularly upbeat, describing it as one of the most resilient developed economies through the global financial crisis. He said Australia was “positioned enviably in the global economy”, with the diversification of being exposed to the US and the emerging economies of Asia, particularly China. He described a typical economic recovery as V-shaped, with a brief recession followed by a consumer-led recovery as the savings rate falls and private debt increases. Housing and banking recover quickly, and the unemployment rate falls quickly. The current recovery would not follow this course, he said, because the recession was deeper and consumers were repairing their balance sheets rather than spending the economy back to health: the savings rate was rising and private debt was decreasing, meaning that housing and banking would recover more slowly. But while the current recovery would likely be longer, slower and more “U-shaped”, nor did he expect a W-shaped scenario – a ‘double-dip’ recession.

The global economic recovery would also be uneven, he said, with the BIC nations of Brazil, India and China driving the world economy, with the major developed nations dragging the chain. (The BICs used to be the BRICs, but Russia’s economy was one of the hardest hit by the GFC: after a collapse in commodity prices and capital flight caused a devaluation of the ruble, Russian Gross Domestic Product slumped by 7.9 per cent in 2009.)

The GFC had left some uncomfortable legacies that would have to be washed out of the global economic system, said Davis. The first was the debt that governments had to incur to fight the crisis, with high debt-to-GDP ratios and government budget deficits acting as a brake on economic growth: this was where the biggest risk of a double-dip recession was to be found. The second was the inflationary risk on the back of the massive government stimulus pumped into the economies. While acknowledging these risks as real, Davis said that the long-term outlook for equities and bonds remained positive.

He said inflation was “probably overstated” as a risk at present, pointing out that in the US, wages were stagnant, pricing power weak and there was significant slack capacity in the economy – all of which pointed to a low-inflation environment in the US. In addition, the behaviour of the banks at the moment was anti-inflationary, he said.

While the prevailing fiscal deficits meant that the world faced lower economic growth in the near-term, Davis said that this did not necessarily correlate to low returns from assets. In fact, the price share investors pay for economic growth – that is, P/E ratios – tends to matter much more than the economic growth rate, he said.

Davis agreed that China was a strong growth story for the world economy – and particularly for Australia – but caution that over the next three to five years, China ran the risk of being reluctant to rein in inflation because it feared such action would knock down growth. While he said the risk of China tightening too far – or too quickly – was present, he felt it was not a likely outcome, although he observed that the flipside of Australia’s strong economic performance on the back of Chinese demand was the risk of exposure to any “frothiness” or volatility in the Chinese economy.

For investors, concluded Davis, all this spells out the need for a keen understanding of risks that prevail for each asset class. With global diversification across the portfolio, care should be taken with the temptation to invest in growth-value investments and the BIC economies and investors should guard against over-reacting to rising rate concerns in building bond portfolios.

Davis’ message to investors was that while they could expect a long, slow recovery from the global financial crisis, they could still earn good returns by sticking to long-held investment principles, such as patience, diversification and strategic asset allocation – everything else tends to be noise, he reminded investors.

And in echoes of his country’s former president Franklin Roosevelt’s line of “all we have to fear is fear itself”, Davis’ parting message to Australian investors was not to “underestimate the impact of sheer animal spirits on the markets”.

“While optimism prevails so, history tells us, does the market,” he said.

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Your Say

Martin Carr, Head of Investor Relations

We asked Joe Davis, Vanguard’s global Chief Economist, to answer some investor questions while visiting Australia in March.

Emerging markets seem intriguing in light of how they have performed in recent years – should I load up my portfolio in this area to take advantage of the economic growth story?

Countries like Australia are expected to benefit from the growth of emerging markets. Emerging market demand for raw material has certainly been the catalyst for the current boom in Australia’s resource sector. And emerging markets as an investment have certainly caught investors’ imaginations given their performance in recent times.

The importance of asset allocation and the risk of diversification are however often overlooked when an asset class is enjoying strong momentum. From recent Vanguard research, Joe highlights the perils of overweighting towards emerging market countries given the historical zero correlation between economic growth and stock returns. While this may sound counterintuitive, the dynamics of increased globalisation of trade and appropriate valuation (compared to past undervaluation) help us understand this notion. Indexing is a strategy that investors can use to ensure that their portfolio is not overweight on a single sector or region which may experience volatility.

With a potentially increased infl ationary environment, does fixed interest still play a role within an investment portfolio?

Policy makers around the world have essentially avoided a worst-case scenario with respect to the GFC. However, this has been achieved at considerable cost in terms of higher deficits and higher-inflation tail risk. Given the mixed outlook for global economic recovery, a broadly diversified fixed interest allocation makes sense. Broad diversification is vital in order to minimise risk in falling markets. Trying to pre-empt investment market changes is inherently difficult, if not impossible, and positioning one’s portfolio against key eventualities will serve most investors well.

A fixed interest allocation plays an important role in an investment portfolio as it provides diversification against more volatile asset classes such as equities, as well as offering a more stable income stream. These characteristics provide a defensive aspect to most portfolios.

For more information on Joe’s economic outlook you may wish to view an interview between Joe Davis and Paul Chin (Vanguard Investments Research and Technical Manager) at www.vanguard.com.au/bnw

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Vanguard’s New Interactive Index Chart

www.vanguard.com.au/indexchart

Vanguard has just launched a new version of our popular interactive index chart. This improved tool now incorporates three different calculators – an index performance charting tool, a portfolio comparison tool and a volatility charting tool.

Index performance
The index performance charting tool enables investors to view the performance of a $10,000 investment in different asset classes over different timeframes demonstrating the rewards of staying invested over the long term.

Portfolio comparison
The portfolio tool provides a way to research and compare existing or virtual portfolios against predefined diversified portfolios and examine the returns over different time periods. This is useful when determining asset allocations for your portfolio and although historical data is not necessarily an indicator of future performance, long term trends may offer some useful wisdom.

Using the index chart portfolio calculator, you can see how outcomes can change by adjusting the asset allocation of the portfolio. The portfolios shown in the image compare a high growth with a balanced portfolio with details of the asset mix, performance and end value of the chosen time period.

Diversifying across asset classes cannot protect you from negative returns, but it can reduce the impact of poorly performing asset classes. While you may not participate in the full sharemarket highs, you may not suffer the extreme lows.

Volatility
The interactive volatility chart enables you to select dates and data to show volatile markets and recovery patterns over a chosen date range between 1970 and 2009 to view how many falls there have been in the sharemarket during that time (Australian or International) and how long it has taken the market to recover to previous levels.

Over the ten-year period the Australian sharemarket experienced two declines of greater than 10 per cent. As the Australian sharemarket is still recovering from its 48.3 per cent fall between October 2007 and January 2009, this period is not included in these two declines.

This calculator defines a fall and recovery period as one that starts when the value of the sharemarket declines and ends the first time the index value returns or exceeds the value of the index immediately before the fall.