A Question of Currency
17 October 2005
Janine Starks - Liontamer
Note on the author: Janine Starks is Head of Investment Solutions for Liontamer. Her early career was spent in the New Zealand wholesale markets as a money market and foreign exchange dealer for ANZ Bank.
Question:
With the NZ dollar at such high levels, shouldn't investors be taking currency risk on their international holdings?
Answer:
We'll take a look at this question from two points of view:
1. Advising investors with new money
- Now we're at 70c – that's a dead cert, isn't it?
- 150% participation could be a better 'dead cert'
2. Advising investors who have suffered in the move up to US 70 cents
- Would a capital protected investment be a suitable recovery tool?
As an introduction, here's how the currency interacts with the sharemarkets:
If the NZ dollar falls in value from its current level of around US 70 cents, it's possible for investors with international equities to make currency gains. It needs to be remembered that equities need to rise for these gains to stay in place. If equities fall in value, the currency gains can be wiped out.
| NZ dollar falls | NZ dollar rises | |
| Equities rise | Investor receives two types of gains | Sharemarket gains can be wiped out by currency losses |
| Equities fall | Currency gains can be wiped out by sharemarket losses | Investor suffers two types of losses |
As you can see from the table, three of the four possible scenarios for investors result in gains being deteriorated or losses doubling up.
1. Advising investors with new money
Investors who are going to buy international equities with currency exposure need to be very aware of the following:
- They need to have a very definite view that the NZ dollar will fall and equity markets will rise at the same time. Any other combination of events will wipe out gains or double up the losses.
- Even if the equity fund is passive in nature, the currency exposure effectively means they will have to actively manage their entry and exit of the fund depending on currency movements. They will need to make sure they exit the fund at times when the NZ dollar is on an upward trend.
- Equities demand a medium term view and currencies demand a shorter term view. This opposing feature makes them very difficult to manage when the risks are combined in one fund. Unhedged equity market exposure is therefore more suited to the investor with a trading mentality who can juggle the combined risks.
- Investors must think about their own risk profile. Adding currency risk to equity market risk is not a low or even medium risk strategy. Risk can be magnified by exposure to two volatile markets.
- Given we live in a small country our currency can be volatile. It also tends to be quite cyclical (see the chart below). Over a five year term, our dollar can go through some massive swings, but unless an investor trades in and out of those swings they will often achieve very little over the medium term. They will also risk being out of the market when equities are performing well (the last two years are a perfect example. Our dollar has been appreciating, wiping out good equity market gains).
- In the last 20 years the average value of the NZ dollar is US 57 cents. An investor who entered the market around mid-1994 would have invested when the currency was at its long term average. If they exited five years later, it would have only been a little lower, having traveled up over 70 cents in the middle of this period. Again in the next five year period the kiwi dropped to US 39 cents and then headed back up. We have to ask what equity market investors achieved by being exposed to the NZ dollar during these cycles. Unless the timing was extremely astute, they probably achieved very little, apart from a wild ride, which few would have enjoyed.
Ok, but now we're at 70c – that's a dead cert, isn't it?
Nothing is a dead cert, but it does look likely the currency could depreciate. Getting the timing right and matching it with equity market appreciation is another kettle of fish.
Right now, the timing is very difficult to pick as the Reserve Bank look set to enter a phase of interest rate hikes. This means New Zealand will maintain it's position as the highest yielding developed country. High interest rates attract investors, who buy our currency to invest, keeping the dollar buoyant. We'll need to see a narrowing of the spread between our interest rates and that of the US, before this changes.
With the dollar now at US 70c investing in international equities currently has merit, for those active investors with more of a trading mentality. There is likely to be a heavy dependence on their adviser picking the right exit point for them – no small responsibility. This is obviously not a buy and hold strategy. It's a shorter term tactical move within a portfolio. These investors actually need to completely exit the equity markets when their currency play is over.
So the big question to ask is whether this tactic really suits the medium to long term growth investor. Secondly, is it wise to have investors who are of a 'buy and hold' mentality heavily exposed to our currency? Are there other options open to them?
In the past, investors have had very few options. In order to follow sensible financial advice and diversify out of a small NZ market, they've had to stomach the currency. Even fund managers who 'hedge', only do so partially and end up wearing a fair amount of the general currency movement.
NZ investors tend to get into a cycle of making currency gains, losing them in the next cyclical move and feeling aggrieved. Or, making currency losses, feeling aggrieved and trying to recover them. Even worse, many have given up on international investing all together. Investors should think carefully about jumping on this treadmill of repetitive cycles as they lead to a nasty mess when combined with equity markets moving the wrong way.
We acknowledge that having a portion of unhedged and closely monitored funds in a portfolio, when the NZ dollar is at 70c, has merit as a tactical play. But for investors with a balanced outlook and a buy and hold mentality this short term tactic is probably only suitable for a very small proportion of their portfolio.
For the majority of investors, diversification into the international equity markets is the goal we are trying to achieve. It is international equities as an asset class which we want exposure to. For these people, we are trying to encourage a medium to long term attitude and the currency movements over this time frame only cause angst.
Advisers are managers of risk, as well as return. So in the interests of risk management, make sure you consider the other options:
A) Partially currency hedged funds which will soften the blow
B) Capital protected funds with a full currency hedge which will eliminate the blows. These are currently very attractive because of the 'pick up' we get from eliminating the currency risk. The additional market exposure is a handsome reward for not having currency exposure. Investors will also have a much calmer ride. See below for an explanation.
150% participation could be a better 'dead cert'
Capital protected investments offer investors an excellent risk management tool coupled with outstanding growth potential. Right now we have a particularly good pricing environment for these funds. To learn more about this make sure you read our article; Too good to be true.
Our Global Series 1 fund offers booster units, which give:
- 1.5 times the rise in a global sharemarket index at maturity (150% participation rate)
- An investment which is fully protected from currency movements as it's based in NZ dollars
- Full capital protection at maturity. If the equity markets fall in value, the investor gets their money back less any entry fee charged.
This fund employs two risk management techniques. It protects investors from falling sharemarkets and eliminates their exposure to a volatile currency. On top of this, it accelerates investors' returns.
Part of the reason we can offer accelerated returns is because the investment is in NZ dollars and not in another currency. There is a valuable 'pick up' available which we translate back into a higher market exposure (i.e. investors get a participation rate of 150%). If we offered this investment in US dollars or British Pounds, the participation rate would fall dramatically. Investors would be lucky to get 80% of any sharemarket rises.
As you can see, NZ investors are rewarded handsomely for not taking the currency risk. By locking in a high participation rate of 150%, they are certain to outperform the sharemarkets. This built-in outperformance compensates for the lack of currency exposure. The NZ dollar would need to depreciate significantly to bridge the gap in participation rates between USD or GBP denominated products and NZD products. Over a five year fixed term it's anyone's guess whether these currency movements would occur. With that sort of time frame our dollar could be back up at 70c again.
Alternatively, investors could give up the capital protection and move into a more liquid traditional fund which would offer 100% exposure to the markets, currency exposure and 100% exposure to sharemarket falls. They could then time their movements in and out of the markets over the next 5 years in the hope they would make astute timing decisions and outperform a capital protected fund with accelerated returns.
When you do the comparisons on a risk / return basis, it's fairly clear that the majority of investors would be suited to the capital protected fund.
| Capital protected fund in NZ dollars | Capital protected fund in GBP or USD | Traditional fund |
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2. Advising investors who suffered the move to US 70c
A common comment we hear is that investors who are sitting on losses in international equities, need to stay exposed to the currency to recoup the losses. The problem for these investors is that they've probably suffered a double whammy. They've had equity market losses with currency losses that compounded the problem. Even worse, while investors in currency hedged funds have recovered a lot of their sharemarket losses in the last two years, those who were exposed to the currency had their gains eaten away by the appreciation of the NZ dollar.
Many of these people have had a right thumping from the currency markets and want to exit when some of their losses are recouped. At what point do advisers tell these investors to get out – 60c, 55c, wait for 50c? One wrong move and the client could have missed the opportunity. Sensible practice employed widely by exporters is to take cover in parts, all the way down. The goal is to keep improving your average. Investors who want to exit unhedged equity funds would be wise to do the same. Cash in parts of the investment on the way down as a risk management technique. No one can pick the exact bottom, so all you can hope for is an average exit rate which is acceptable.
It's important not to be too greedy on any currency depreciation. If they invested when the currency was well below its long term average e.g. US 40-45 cents, it might be unreasonable to expect the currency to get that low on the next down turn. If they hold on too long waiting for the next bottom, they might miss the boat and simply end up riding it back up again. Timing will be everything.
Investors can't just watch the fund value and wait for it to come back to par. Equity markets and currency markets could move in opposite directions at different times. Regardless of what is happening to the fund value, when a reasonable NZ dollar level is reached, it could be wise to jump into protected funds or partially currency hedged funds.
Would a capital protected investment be a good recovery tool?
Investors who have been stung by both equity market and currency losses need strategies which will aid in a recovery. One option we've already discussed is to simply stay put and exit from these funds in several chunks as the currency depreciates.
Another strategy is to consider a capital protected investment. Investors need to consider investments with accelerated growth to aid in their recovery. Simple maths tells us that a 30% loss requires a 42% gain to get back to par – the climb back up is bigger in percentage terms than the original fall. The recovery would be helped by a fund which gave more than 100% exposure to market rises. For example, our GLOBAL Series 1 booster units give 1.5 times the rise in global sharemarkets. A 30% rise would translate into a 45% return to investors. Our fund has no exposure to the currency, but the accelerated growth feature provides a different approach.
For those sitting on losses, it would seem sensible to employ more than one strategy to fuel the recovery. Keeping investments in funds with exposure to the currency isn't the only option – capital protected funds with accelerated growth are most definitely another avenue to consider.
NZ Dollar – 1986 to 2005
Source of chart: Deutsche Bank / Bloomberg
High: 0.7315
Date: 29/04/05
Low: 0.3939
Date: 31/10/00
Average: 0.5758
Dates: 1986-2005
Important notes about Global Series 1 booster units: This article is for information purposes only and is only a brief summary of the key facts. Full details are contained in the Investment Statement and Prospectus, which can be obtained from your financial adviser or Liontamer Investor Relations on 0800 210 451. Although the Note Issuer (Barclays Bank PLC) is legally liable to repay the investments owned by the trust and all returns on those investments, neither the Note Issuer nor any other entity guarantees the repayment of units or any returns on the units, nor accepts any other liabilities to unitholders. Past performance of the sharemarket should not be used as a guide to future performance. The final level of the Liontamer Global Index is averaged in the last year of the term. This aims to protect you from sharp falls at the end of the term. In a rising market averaging lessens returns.
