Do Foreign Currency Returns Matter?
Planning is bringing the future into the present so that you can do something about it now.
Whilst many prefer the comfort of investing in familiar “homegrown” companies, there may have been instances where you have been exposed to investments listed in overseas and foreign currencies. Not long ago, many Singaporean investors were caught up in investing in products denominated in Australian dollars (AUD). They may have wanted to gain AUD exposure due to the possibility of their children studying there, or because they believed AUD would remain strong for some time.
Sometimes such a foreign currency exposure works against you and despite making money in the underlying investment, you experience losses overall from the depreciation of the currency. Many investors got into AUD at S$1.30 and now with the currency at S$0.97 it represents a decrease of 25% on forex losses alone. This could be a similar story if you held investments in the British Pound (GBP) or even closer to home, in Malaysian Ringgit (MYR).
However, being exposed to global stocks and currencies is actually a good thing - you just need to be more broadly exposed. For investors with unhedged foreign investments, when their home currency appreciates, it has a negative impact on returns; conversely, when it depreciates, the impact is positive. How can investors make an informed decision about whether they should hedge currency exposures and when they should do so?
Using data on 12 developed markets over more than 30 years (1985 to 2019), recent research by Dimensional Fund Advisors shows the impact of currency hedging on expected returns and volatility for global equity and fixed income portfolios. An important takeaway for investors is that currency hedging decisions should depend on their asset allocations and investment goals.
The impact of currency hedging depends on how volatile your investments are relative to the currency you are exposed to. It is a known fact that stocks are generally more volatile and as such, affect your investments more than bonds. However, when it comes to foreign investments, exposure to foreign currency will affect your bonds more than stocks because it is less volatile. The chart below shows the different asset allocations (in terms of equities and bonds) and the differences between hedged and unhedged portfolio.
As there are costs involved in hedging, the returns between the hedged and unhedged portfolios will differ. Significantly, investors who are more risk averse and hold more bonds will benefit greatly from hedging their bond exposures back to SGD. This is important as the SGD bond market is not very diverse and quite limited. As such, many investors will have to hold bonds in foreign currencies. If these exposures are not hedged back to SGD, this directly affects their risk exposure and returns.
The research also highlights that foreign currency returns are largely unpredictable and hedging based on forecasts and predictions of currency movements are unlikely to add value.
At the end of the day, currency hedging is among the many aspects to consider when building and gaining exposure to global portfolios. Robust framework backed by rigorous research like the one shown in the study can help investors make well-informed decisions to better achieve their investment goals. We recommend that some of your exposure - especially the bond components - be hedged back to your home currency to ensure that your returns are stable. However, everyone’s circumstances differ. If you are unsure of what risk you are taking with your investments in terms of currency exposure, speak to your advisor to find out how they can help you further.
