To hedge, or not to hedge?

The fear of wild currency swings often deters people from investing overseas. But if you’re investing in countries with relatively stable currencies, and you’re a genuine long-term stock investor, then over the course of a business cycle it’s likely that currency fluctuations will wash out.

If that’s the case, your returns will mirror those of the stocks you purchase. The point is to worry more about the businesses you or your fund manager buys, rather than the currency.

In the Peters MacGregor Global Fund, we can hedge currency risk, but we typically only hedge when currency rates threaten to cause major losses to the portfolio. We hedged against falls in the Australian dollar a few years back when it was around parity with the US dollar, for example, and currently we have hedged our exposure to the Chinese Yuan.

We own Chinese technology companies Tencent, the owner of the WeChat messaging service, Baidu, China’s answer to Google (now Alphabet), and, commonly referred to as the Amazon of China, albeit there are major differences.

The tailwinds blowing behind these businesses are huge and they dominate their markets, but we don’t want a major one-off devaluation of the Chinese Yuan to impact our portfolio. As China’s debt increases and growth slows, there’s a high risk that a devaluation could be used to stimulate the economy.

The key point is that we don’t hedge very often. Over the years each time I’ve read the results from a fund manager’s review of their hedging, they lament the time and cost of hedging which hasn’t helped their results. I’m sure there are exceptions to the rule, but history is littered with the carcasses of businesses and investors that bet wrong on currencies, which is why we only consider it as a form of protection.

The Australian dollar is currently around the historical average against the US dollar. With debt levels reaching unprecedented levels in China and Australia, at some point investors will be glad they have some overseas currency exposure to mitigate poor returns from a lopsided portfolio of highly leveraged, cyclical banks, resources companies and direct and indirect property holdings.

It’s important to remember that in a serious downturn the correlation of most assets becomes one (i.e. they all move in the same direction), so currency diversification remains one of the easier ways for investors to reliably diversify their portfolios.

With only 1-2% of SMSF assets reportedly invested abroad, it’s a good time to review your currency exposure while the Australian dollar is at or above historical averages against the major currencies.

Risky means of diversification

Both the numbers and my recent conversations with investors suggest the average Australian currently has too many eggs in one financial basket. After an epic 25 years of strong property prices that have stimulated huge returns and dividends from the big banks, the focus should now be on how much more debt can we handle before the cycle switches into reverse.

How would your portfolio perform if Australian stock and property prices fell, dividends were cut and the Aussie dollar fell substantially to stimulate exports and attract the foreign investment needed to support our banks? Some of these falls would likely be more permanent than temporary.

Unfortunately, too many words have been spilt recently recommending risky solutions to these fears, such as buying passive products such as index funds and ETFs based on a broad index of US stocks.

The US stock market is likely the most overvalued currently, due to stocks like McDonald’s. Despite its earnings being stuck at 2009 levels, it’s price-to-earnings ratio has doubled from 13 to 27. Why would anyone pay nearly 30x earnings for a company that isn’t growing?

Most people wouldn’t, which is why passive funds are likely behind the move. They pay no attention to value but, as Warren Buffett warns, eventually value matters. McDonald’s isn’t an orphan, either, there are scores if not hundreds of expensive companies like this that people own unknowingly through ETFs and index funds. This is a good example of the limitations of diversification; more is not always better.

What’s worse, is that there are no natural buyers for stocks that ETFs will be selling en masse during the next downturn as, unlike a closed fund like a listed investment company, ETFs expand and shrink as demand fluctuates for their units. This ‘feature’ doesn’t seem well understood by those at most risk from falling share prices.

Right now, volatility is at an all-time low, and markets are calm. This won’t last forever, so now’s the time to review your foreign currency exposure (most Australians hardly have any, leaving them vulnerable to a local recession), what assets you own and why, and to consider what strategies will perform over the next decade which, for Australia at least, promises to be much more difficult than the goldilocks 25 years we’ve recently enjoyed.

Disclosure: Peters MacGregor Capital Management Limited holds a financial interest in Baidu, and Tencent through various mandates where it acts as investment manager.

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