The currency impact on your overseas shares and what you can do about it

Australian investors are constantly told that they need to diversify their share portfolios, away from the heavy concentration risk of the big local banks and the big miners which account for more than half of the benchmark index.

While there are good reasons for the heavy bias to local shares – the yield boost from franking credits in particular – Australian investors need to diversify their holdings internationally. It is not only that Australia represents just 2% of the investable global stock market; moreover, the Australian market simply does not have a lot of industrial sectors and potential investments. For example, it does not have major technology stocks, global pharmaceutical players, and global consumer goods companies – which have revenue streams from all over the world.

According to the latest Australian Taxation Office statistics, self-managed super funds (SMSFs) hold a tiny $2.2 billion directly in overseas shares – just 0.4% of the total SMSF holdings – although there could be more international exposure in the $52.5 billion they hold in managed funds.

The currency equation

For many, what puts them off global shares is being exposed to exchange-rate movements – currency risk.

Currency volatility can substantially alter profits and losses on international shares. If you make a capital gain on foreign shares, what matters is what happens when you convert your profit to Australian dollars.

The currency risk posed by the A$ must always be factored into the decision to invest money overseas. But while the volatile A$ can potentially slash any gains made, it can also increase them, in the right circumstances.

In essence, the currency effect on overseas investments can go one of four ways, doubling the risk of simply buying an overseas stock.

Say you have made a capital gain on some foreign shares. If the A$ falls against the currency in which the shares are quoted, your capital gain increases. But if the A$ strengthens against the foreign currency, your capital gain is less – and could even be taken away completely.

Conversely, if your foreign shares fall in price, you hope that the foreign currency in which the shares are quoted rises against the A$, to offset some of your capital loss. But if the share price falls and the foreign currency weakens against the A$, you will face a ‘double-whammy’ loss: where the rise of the A$ worsens your loss on the investment.

In practice

For example, imagine you bought 100 Microsoft shares in April 2010, with the share price at US$30.70. The purchase cost US$3,070, which, with the A$ buying 92.2 US cents at the time, cost you A$3,330.

Three years on, your Microsoft shares are trading at $40.29, for a nice gain of 31%. And fortunately for you, the A$ has weakened substantially over the five years, and now equates to 76.3 US cents. In A$ terms, your shares are now worth $5,280, for a capital gain of 58%. You’ve had the positive double whammy of appreciating shares, and weakening A$.

Now imagine that the A$, which reached parity with the US$ in October 2010, had stayed there (it was last at parity or above in May 2013). What if the A$ were still buying US$1.05? In that case, your 100 Microsoft shares would be worth A$4,230 – and your capital gain on the shares (in A$ terms) would be just 27%.

Some professional investors do not mind taking currency risk – they view it as another layer of diversification. They say that they are stock-pickers, not currency experts, and they expect the long-term capital gains on the shares they buy will more than compensate for currency fluctuations.

Other professional investors get around this uncertainty by hedging their overseas share exposure back into A$, by locking in a known rate of currency exchange for their investment gains, so that they pick up only the movements in the overseas shares, in the local currency.

The trade tools

But for retail/SMSF investors, it is a scary thought that the Australian dollar has moved from US$1.08 (when it was floated in December 1983), to a low of 47.75 US cents in April 2001, back to parity with the US$ again in October 2010, to a record high of US$1.10 in July 2011, and back to 76 cents. It is a highly volatile currency.

There are certainly products that can allow retail investors/SMSFs to profit from currency movements: they can use contracts for difference (CFDs), margin FX, options and futures contracts (standard and mini-sized), all of which offer leveraged exposure to exchange rate movements, where you pay interest on a long position and receive interest on a short position.

Also, currency MINI warrants traded on the Australian Securities Exchange (ASX) allow traders to take a leveraged position on the $A rising or falling against the range of currencies: Citi has a series of long and short MINIs over the A$/US$, A$/pound, A$/euro, A$/yen and A$/NZ$ rates.

While these are essentially vehicles for short-term currency trading, retail investors trying to hedge their overseas investments can use them all.

For example, an investor may want to take a currency position on US$100,000 for a month. With the A$ trading at 76 US cents, the investor could buy a put option with a strike price of 75 US cents, locking in this exchange rate.

A month later, the A$ may have dropped to 68 US cents. But the investor would be able to sell at 75 US cents by exercising the option – and not have to sell at the current spot rate.

Investors must be aware that the cost of using options will vary: the longer the time horizon, the more expensive the premium. It can also be difficult for retail investors to get a forward exchange contract beyond a year: you would need to ‘roll-over’ the contract every year.

Another option for investors is the US Dollar ETF from Betashares, which trades on the ASX under the stock code USD.

Important: This content has been prepared without taking account of the objectives, financial situation or needs of any particular individual. It does not constitute formal advice. Consider the appropriateness of the information in regards to your circumstances.