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The impact of currency

When an investment is made in overseas shares, the return that the investor receives is a combination of the performance of the shares, the movement in the exchange rate and the currency hedging policy. Investors can choose to be exposed to the movement in the exchange rate or to remove (i.e. hedge) the impact. If overseas shares are hedged, the investor does not gain or lose from currency movements.

Often, the movement in the exchange rate dominates the return over the short-term. This is seen by chart 1. Chart 1 plots the return from shares (horizontal-axis) against the impact of the currency, i.e. the exchange rate movement, (vertical-axis). The returns are each of the quarterly returns over the last 25 years (100 quarters) to 31 March 2012.

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Overall, the graph indicates that there is no pattern. The return from currency ranges from -10% to +13% and the return from the shares (excluding currency) ranged from -25% to 20%. Remember, these are quarterly returns. Also, 68% of the time, the share return was positive and 59% of the time, the currency impact was negative. Historically therefore, investors have benefited from being “currency hedged” i.e. removing the currency impact.

Chart 1 shows that the impact of currency is significant and therefore not necessarily something that should be left to chance. For the currency returns to be positive, the NZ dollar must fall so the overseas currencies can buy more NZ dollars. When the currency return is negative, it is because the NZ dollar has strengthened (gone up). So a falling NZ dollar for an unhedged investor, enhances the returns and a rising NZ dollar reduces the returns.

The returns on a quarterly basis can also be grouped by whether the share return and/or the currency return is positive or negative. The “nil-return” line in chart 1 indicates where the positive currency return offsets the negative share return and vice versa. Ideally, an investor wants to be in shares where the return is at the right of the nil-return line, i.e. where the total return (currency + share return) is positive. Also, see Table 1

Table 1 highlights that the returns from each source are often opposite. It also highlights that the reason to invest in overseas shares is to capture the positive return from the overseas share market (about 70% of the time). The return from currency should be a secondary consideration.

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Where will the NZ dollar go from here?

We do not know the answer to this question. The current trend appears to be for the NZ dollar to go up against most currencies that matter to the global sharemarket pools, (Euro, UK pound, US dollar). This trend reflects the weaknesses of the European and North American economies, and the cash flows to or from them, as opposed to the NZ economy being vibrant. We expect this trend to continue until the fiscal issues in the European and North America economies are or will be addressed. The recent trend of the NZ:US exchange rate is indicated by the graph below. Chart 2 plots the moving 6 month average exchange rate. This plots the trend without the “noise” of the day-to-day fluctuations over the last 10 years. Over the last 10 years, the general trend is up, but for how long will this general trend continue?

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SuperLife options

Under SuperLife, members can invest in overseas shares on a “currency hedged” basis and on an “unhedged” basis. Currency hedged means that the impact of exchange rate movements is largely eliminated from the return and unhedged means that the member is exposed to the exchange rate movements. Members can combine the two options in any way they wish, and change the allocation between the two options, for the future at any time.

For most of the standard SuperLife strategies, the default position is 50% hedged: 50% unhedged. In the AIM strategies, this always applies. In contrast, in the Managed strategies, SuperLife varies the split based on its view.

SuperLife's current position

Currently, where SuperLife has discretion, for example in Managed60, it is 71% hedged and 29% unhedged. This is because SuperLife thinks that the NZ dollar is more likely to strengthen (go up) over the next six months. However, the Trustee is conscious of potential disasters (e.g. Europe, foot and mouth disease, earthquakes, etc). A disaster could see the dollar fall unexpectedly. SuperLife is also conscious that part of the reason for investing overseas is to diversify away from the New Zealand economy.

Where SuperLife has discretion on the split between currency hedged and unhedged overseas shares, the current position has a bias to being hedged.

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The legal stuff

The above article is a general investment commentary. It should not be considered as being personalised financial advice. Members should obtain appropriate financial advice from a suitably experienced Authorised Financial Adviser, before making any investment decisions. Only an Authorised Financial Adviser can legally take into account the person’s personal circumstances. SuperLife does not give personalised financial advice.