What goes down must come up

By PHILIP MACALISTER

Investors with money in overseas assets may be in for a shock when they see their March-quarter statements - a rising Kiwi dollar will have wiped out any gains the foreign markets have made.

Since about 1997, the New Zealand dollar has been in constant decline (except for the odd blip), falling from around 70USc to below 40USc last year.

This trend has been taken as a given, and fund managers who invested in international shares could justifiably choose to leave their investments in foreign currency (as opposed to hedging them back to the New Zealand dollar) and accept the free lunch.

But as we know, there is no such thing as a free lunch. Now that the kiwi has swung around and started rising against the greenback, hedging policies are being revised.

(The US dollar is arguably the currency that matters most to New Zealand investors because about 60 per cent of the stocks in the MSCI index are denominated in greenbacks).

The turnaround is particularly significant for New Zealand investors because they have embraced the need to diversify into overseas assets, and their returns have been spiced by the kiwi's fall.

One question which is consequently raised is: have investors diversified their currency exposure too?

The associate director of Endeavour Funds Management of Sydney, Greg Wilson (who worked for WestpacTrust in Wellington), points out that investors are good at diversifying their assets, yet they do not use the same logic when it comes to their currency exposure.

"There is a perception that holding assets denominated in foreign currencies is more risky than holding assets in the local or base currency."

This bias, he says, can lead to poor investment decisions and portfolios being under-diversified with regard to currency risk.

"The New Zealand dollar is arguably the largest risk in any portfolio, but it is the exposure to foreign currencies that is considered to be high risk."

David van Schaardenburg, head of managed fund research house FundSource, agrees.

He says that if investors believe in the global economy and diversification, it is unwise to hold all their assets in one currency.

For example, if all your assets were in New Zealand dollars, and a catastrophe such as a major earthquake or foot and mouth disease struck the country, the dollar would probably plummet, effectively reducing the total wealth of New Zealand as a nation.

Wilson says: "We regard the New Zealand dollar as riskless when the reality is quite different. An investor's exposure to the New Zealand dollar is probably the largest unmanaged risk in their portfolio."

The questions arising from this are: can you predict the currency movements, and what can you do to mitigate the situation?

Predicting the movement of currencies is difficult at the best of times. It could even be argued that managers in New Zealand have not spent much time looking at the issue because it is too hard or they believe that the kiwi is in an irreversible, long-term decline.

Van Schaardenburg says it is theoretically possible to successfully manage currency actively, yet few managers do because it is so difficult.

There is an argument to actively manage currency because the kiwi can be volatile. Even if it is in a long-term trend one way, there are short-term trading opportunities.

This raises the question of what sort of hedging strategy is most important for New Zealand investors?

When it comes to bonds or fixed interest, the numbers are categorical.

Frank Russell director Ed Smith says the comparative returns between hedged and unhedged bonds depend on the direction of the New Zealand dollar, and this varies from time to time.

But picking currency movements is notoriously difficult, and a bad decision can have a devastating effects on returns.

By contrast, the risk of hedged bonds is substantially less than for unhedged bonds.

One factor supporting this position is the nature of bonds.

"They are naturally a low-risk, low-return asset," Smith says. "Their purpose, in a portfolio context, is to diversify and reduce risk."

He says currencies are volatile and hard to predict, and when currency movements are added to bonds, the investment becomes a higher-risk asset, without necessarily improving returns.

"This suggests that New Zealand investors should have a natural preference for bonds where the currency is predominantly hedged to New Zealand dollars."

It is no surprise, then, that FundSource says most of the 10 global-bond funds offered in New Zealand have a policy of hedging their portfolios fully.

However, when it comes to international shares, history paints a different, and potentially confusing, picture.

Frank Russell research concludes that there is not enough evidence to suggest any systematic difference in the risk of hedged and unhedged shares.

"The rational explanation of this is that shares are a high-risk asset," Smith says. "Therefore, rational investors will invest in them only if they can expect higher returns. The additional risk imposed by foreign currency exposure is relatively small."

What should investors do?

Van Schaardenburg says currency is complex and a difficult area for adding value to an investment. It is best left to professional fund managers. But he warns investors to be fully aware of their managers' policy and practice.

Currency issues must be built into a portfolio and the most appropriate funds should be picked.

"Currency is a risk-management issue, not a return issue."

Smith says it is appropriate for investors to consider currency.

"Nobody likes the short-term losses that can arise from rapid and powerful currency movements. But at the same time investment decisions need to be made in the light of the investor's objectives and a coherent strategy and be based on recognition of true ability to forecast currency movements."

He says currency management must be considered independently of the decision to invest abroad.

While the difficulty of managing currency exposure is clear, what is now apparent is the impact currency has on a portfolio when it moves in a different direction.

* Philip Macalister is the editor of online money management magazine Good Returns. Good Returns provides news on managed funds, mortgages, insurance, superannuation and financial planning. Email philip@goodreturns.co.nz