Current-cy Pains
Key Takeaways
The lack of SGD investment options and the desire to access an expanded opportunity set naturally come with exposure to foreign currencies. It is important to be aware of and cater for forex movements in your portfolio.
When your foreign investments are unhedged, a SGD relative appreciation results in a negative impact on returns; conversely when it depreciates, the impact is positive.
Research shows that this impact is felt far more sharply in lower volatility instruments relative to currency (e.g. foreign currency deposits and bonds) than higher volatility instruments (e.g. equities).
Thus, it is especially important to hedge instruments like foreign currency bonds, especially if they’re in a portfolio that’s meant to provide you with a sustainable income as you grow older.
“There are known knowns. These are things we know that we know.
There are known unknowns. That is to say, there are things that we know we don't know.
But there are also unknown unknowns. There are things we don't know we don't know.”
— Donald Rumsfeld
If you have been taking holidays overseas recently, you would have been pleased with how strong our local currency has been versus other major countries such as the US, Japan, Australia and, Europe.
Singapore dollar hits new 2024 high amid tighter monetary policy view
— Straits TimesSingapore’s Holidaymakers Toast Strongest Dollar in a Decade
— Bloomberg
There can be many reasons for the differential in the strength of various currencies, which are primarily determined by individual countries’ central banks. If you are planning upcoming overseas trips or frequently buy items from overseas, you may rejoice. If you are an exporter or have foreign currency investments, then you may be thinking otherwise.
However, due to the lack of SGD investment options as well as wanting to access an expanded opportunity set which naturally comes with exposure to foreign currencies, many investors may be holding various global currencies in their investments. For investors with unhedged foreign investments, when their home currency appreciates, it results in a negative impact on returns; conversely, when it depreciates, the impact is positive.
The negative impact of local SGD appreciation is felt more keenly when your investments are in lower volatility instruments like foreign currency deposits, structured deposits, and foreign currency bonds. For investments which have similar or higher volatility to currency, like equities, then the impact is not so pronounced.
The chart below shows the returns of equities and fixed income (both hedged and unhedged). As you can see, there is not a significant difference for equity returns (Fig. 1), but it is very much more pronounced for bond returns (Fig. 2).
As a result, for investors with high allocations to stocks, hedging currencies does not meaningfully reduce return volatility. In contrast, for investors with high fixed income allocations, currency hedging is an effective way to reduce portfolio volatility.
As such, we want to highlight to you, our clients, the framework we use when approaching exposure to foreign currency assets asset while balancing risk and return outcomes.
Direct Allocation to Foreign Currency Assets
Our typical response to the question: ‘How much foreign currency should I hold?’ is another question: ‘Where do you intend to spend and use your money?’
If you intend to spend most of your time in Singapore, then your spending requirements will be in SGD. As such, any foreign currency exposure should be hedged back to the base currency of your spending needs.
If you intend to spend 6 months in Singapore, 3 months in the US, and another 3 months in Australia, then it would make sense to have some direct exposure to both USD and AUD currencies or investments.
Conservative or Aggressive Portfolio
For portfolios which are in our local SGD currency but have underlying global exposures, we need to remove possible forex movements to smoothen out volatility and reduce variations. As such, some of the investments need to be hedged back to SGD; it is typically done on portfolios which have higher exposures to fixed income.
The chart below shows that the standard deviation (or volatility) of portfolios which have a larger proportion of bonds is significantly higher than a similarly hedged portfolio. In addition, the dispersion between the min and max returns is very wide for unhedged portfolios.
As such, investors who are focused on income generation and could have a large allocation to bonds in their investment portfolio should be mindful that currency effects do not lead to a negative outcome over time.
The simple example below illustrates this point.
An investor bought an AIA bond in Jan 2023 to receive a 3.2% yield. At that time because that bond was trading below par of 100, the investor bought it at a “good price” of USD$96.359. Because of currency effects, the investor had to pay S$129.46. The income the investor received in SGD was S$4.30.
Fast forward to today — as the bond is about to mature, it is trading near its par value of 100. In USD terms, the investor should have made a +2.86% capital gain. Due to currency effects however, the investor sits at a small loss in SGD. In addition, the income received is lower as well.
We never know the direction of how the currency can move. But as we have seen, barely twenty years ago, the SGD was $1.7 to $1 USD. As such, we should be mindful of how we allocate to foreign currency investments as the forex movements can have negative effects. For our core portfolios in SGD, the fixed income exposure is by and large hedged back to SGD to negate foreign currency movements. For equity exposures, our preference is to avoid hedging due to its cost, which we have determined as not worth its price for, at least at this point in time.
Currency hedging is among the many aspects to consider when building globally diversified investment portfolios. A well thought out approach backed by academic research can help us help you better achieve your investment goals over the long term. For more info, come and have a chat with us.
