Alan Polley: Consider foreign currency exposure in international share portfolios

As the Aussie hits multi-year lows against a rising US dollar, is it time to currency-hedge international portfolios? Pendal’s ALAN POLLEY argues the ‘yes’ case

• Strong diversification benefits in foreign currency exposure
• Low Aussie dollar offer hedging opportunity
• Find out about Pendal’s multi asset funds

INVESTORS should consider hedging foreign currency exposure in international share portfolios as the Aussie dollar hits 2½ year lows against a rising US dollar, arguesPendal’s Alan Polley.

The US dollar’s strength has been the big story of 2022 as the Fed battles inflation by lifting interest rates at the fastest pace since the ’80s.

Higher rates are drawing in money from overseas investors, sending the value of the US dollar higher.

The Australian dollar traditionally offers investors natural diversification benefits because it tends to fall when global markets fall, softening any global declines for local investors.

But at current levels it could pay to think about reducing foreign exchange exposure, says Polley, a portfolio manager with Pendal’s multi-asset team.

“At this point in time, with the Aussie dollar very low versus the US dollar, it’s just natural to ask how much FX exposure should we have and if now is a good time to hedge a little bit more.

“The US dollar on our metrics is becoming expensive — and historically the AUD tends to find support around these levels.

Australian dollar to United States dollar

“It has positive momentum – the US is increasing cash rates at a greater rate than we are – but in long-term investing, you should focus a bit more on the valuation metric. Buy things when they are cheap.

“Arguably the Australian dollar versus the US Dollar appears on the cheap side.”

Foreign exchange exposure is an important consideration for Australian investors who are increasingly holding offshore assets in their portfolios.

“There are strong diversification benefits just by having foreign currency exposure,” says Polley.

“The Australian dollar is seen as a ‘risk-on’ currency – that means in a risk-off environment, the Australian dollar tends to fall.

“If your international equities are falling, typically the Australian dollar might fall as well and that provides an offset for international equities. That diversification benefit from FX exposure is quite valuable.

“There’s not that many defensive exposures in the world. Owning developed-world foreign currency provides significant diversification benefits at the whole portfolio level.”

The right exposure

So what’s the right way to think about the optimal level of exposure?

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Polley says investors can best understand the effects of hedging in a portfolio by considering what happens if you take a theoretical fully hedged portfolio and then start introducing currency exposure.

“What tends to happen is the volatility of the whole portfolio comes down because of the diversification benefits from adding foreign currency exposure.

“But as you keep increasing the amount of foreign currency exposure, the diversification benefits become marginally less and the incremental volatility of currency starts to dominate.

“That means the more currency exposure you have, at some point the volatility of the overall portfolio starts to go up.

“So theoretically there’s an optimal – or a volatility minimisation – point.”

Important considerations

There are other considerations to keep in mind, says Polley.

“As the amount of currency exposure gets large, you’re exposed to the risk of a sustained rise in the AUD.

“Also, future correlations may be different to the past and expected diversification benefits may not arise.

“Lastly, we tend to invest overseas for the offshore assets, so the currency exposure is more a by-product than an explicit aim.”

For most Australian investors, a 20 per cent FX hedge ratio on an international equities portfolio will balance these considerations — and should also mitigate overt sensitivity to FX movements, says Polley.

“You’re getting diversification benefits by having some FX exposure, but you’re not having too much of a good thing.”

How can you do that?

“Consider buying a hedged international equity product and have that at about 20% of your international equity portfolio.”

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About Alan Polley and Pendal’s Multi-Asset capabilities

Alan is a portfolio manager with Pendal’s multi-asset team.

He has extensive investment management and consulting experience. Prior to joining Pendal in 2017, Alan was a senior manager at TCorp with responsibility for developing TCorp’s strategic and dynamic asset allocation processes covering $80 billion in assets.

Alan holds a Masters of Quantitative Finance, Bachelor of Business (Finance) and Bachelor of Science (Applied Physics) from the University of Technology, Sydney and is a CFA Charterholder.

Pendal’s diversified funds provide investors with a variety of traditional and alternative asset classes and strategies.

Find out more about Pendal’s multi asset funds:

• Pendal Multi-Asset Target Return Fund
• Pendal Sustainable Balanced Fund
• Pendal Sustainable Conservative Fund

Contact a Pendal key account manager here