How to manage currency risk in your portfolio

There’s a never ending stream of financial gurus encouraging you to reduce risk. Foreign exchange movements certainly add an extra layer of volatility to your portfolio if you own international stocks, and we want to use this article to explain a few strategies to reduce these currency effects. But before we get to the risk-reducing part, it's worth asking yourself whether you need to reduce this particular risk at all.

Most studies on the predictability of exchange rate movements suggest that short-term forecasting is basically impossible. There is some evidence that currencies move towards purchasing power parity over the long term but, as far as the next few years go, you might as well assume currency movements are random – they may move in your favour, they may not, you just don’t know.

Hedging strategies to reduce currency risk always come at a cost. If you can afford the downside, why bet against yourself and incur extra fees when the outcome is random? It’s a bit like a billionaire insuring his or her Volvo against hail damage, despite insurance policies having a negative expected value. If you’re well off and know that your portfolio will cover your cost of living, with plenty to spare, you may decide that incurring a little currency risk isn’t a bad thing. It may be better to simply manage your exposure to different currencies and stay diversified, rather than try to reduce volatility using one of the hedging options below.

Look for funds that hedge

Let’s say, though, that you only have a modest portfolio, you’re close to retirement, and most of your future expenses are likely to be in Australian dollars. It may be a good idea to eliminate some or all currency risk. The last thing you want is for your nest egg to be denominated in a foreign currency and then in the months before your retirement some calamity wipes 10% from your net worth because of a currency swing.

You have a couple of options. The first is to only buy Australian companies listed on the ASX. Woolworths (WOW:ASX) or Westpac (WBC:ASX), for example, add practically no currency risk to your portfolio because their earnings are in Australian dollars, as is their stock. 

If you want exposure to overseas companies, however, but don't want currency movements to impact your return, the cheapest and easiest way to eliminate currency risk is to buy international exchange traded funds (ETFs) that are hedged back to Australian dollars, such as the Vanguard International Shares Index Fund - Hedged (VGAD:ASX). These funds track international indexes but use derivatives to remove the impact of currency fluctuations. You incur a slightly higher management fee (0.21% vs 0.18% for the fund above relative to its unhedged version), but this is a much cheaper option than trying to do it yourself because the investment manager can get wholesale prices.

Beware DIY derivatives

If you want to buy stocks individually rather than own a fund, things get a lot more tricky. You'll need to get familiar with currency derivatives – options and futures – which can be bought directly through most of the big brokers. Unfortunately, options are usually expensive and can easily cost 5% or more of your portfolio’s value each year, which takes a big bite out of your return.

Alternatively, you could buy a leveraged currency focused ETF that profits from a strengthening Australian dollar, such as the BetaShares Strong Australian Dollar Fund (AUDS:ASX). These funds magnify the returns of currency movements using derivatives, but management costs still come to 1–2%, which is pricy in a world where your investment returns are likely to be in the mid- to high-single digits. These funds also tie up capital that you could be putting to use in other investments.

 If you have a multi-million dollar portfolio there are some cheaper options, such as a currency overlay, available through private bankers and specialist firms, but these are out of reach for most investors (if anyone knows of a company that offers this for non-institutional clients, we’d love to hear about it).

One final option – and the one we loath the most – is to use contracts for difference (CFDs). Be warned, though, this adds all sorts of other risks, such as liquidity issues, margin calls, and counterparty risk. Not to mention holding costs are higher than any other option, so we recommend you steer clear of CFDs altogether.

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