I have a confession to make. There's a small drawer tucked away in my house where I have amassed a collection of ziplock bags, each with the remaining foreign currencies of different countries I have travelled to over the years.
I'm tempted sometimes to convert them all back to Hong Kong dollars - but I never know when I might visit these countries again and need it. When I do travel again, I invariably forget to take it on my trip, end up exchanging some more money and also bringing back more for the ziplock.
But truth be told, I have no idea how much (or what) I have in total and whether converting it back to HKD is the right call right now.
Does your portfolio resemble my drawer? A random jumble of different currencies? How should we all think about our currency exposure?
Understanding foreign exchange (FX)
Foreign exchange ("FX") is a funny one. We don't know whether it is a separate asset class or just a medium of exchange between asset classes. But what we do know is that there is a heavily traded financial market for it.
In fact, more money is traded on the FX market than any other financial instrument in the world. An estimated US$7.5 trillion is traded daily compared to the paltry $84 billion in equities worldwide. So is it an asset class, a medium of transaction, a tool for hedging or risk management? Is there an intrinsic value in the currencies and can it be an important source of returns?
While in the past FX was considered just a medium of exchange, it is now established as a non-traditional, uncorrelated asset class of its own and used for the purpose of diversification.
For most of us, it’s not easy to forecast where exchange rate movements will be going, whether it’s tomorrow, next week or next few years - they may move in our favour, or they may not.
To hedge or not to hedge
Most of us understand the benefits of having a globally diversified portfolio to move away from home country bias. However, when we invest in global equities and bonds (whether directly or through a fund), our portfolios are exposed not just to the underlying securities but also to foreign currency risks.
The question to ask is then, whether you should layer foreign currency risk on top of your portfolio risk.
Based on research by Dimensional, looking at data from 12 markets from 1985 to 2019, the takeaway is that currency hedging decisions ultimately depend on the asset class being invested, investment goals and time horizon.
When the volatility of currency exposure is higher than the volatility of the asset class you are invested in, then FX risk will add overall volatility for your portfolio. For example, currency movements are generally more volatile than bonds and therefore dominates the overall volatility of a global bond portfolio. While for stocks, the impact is not as high as stocks itself is an asset class that has high volatility.
Our advice on managing FX exposure for your portfolio
As confirmed by Dimensional’s study looking at data from 1985 to 2019, monthly currency returns are largely unpredictable. Instead of taking a bet on the direction of a certain currency (whether it be Japanese yen or the British pound).
We therefore advise clients to focus back on your investment goal and objectives. If your investment portfolio is for long-term general wealth accumulation or retirement planning and not short-term speculation, the role of currencies should be focused on managing asset-liability matching.
Hong Kong-based investors who have HKD liabilities (spendings and debt obligations) in HKD, should consider matching assets (savings and investments) in the same currency.
Investing in a portfolio that is not hedged back to your local currency liabilities creates a needless additional layer of risk, especially in fixed income.
Research by Vanguard has also shown, currency accounts for more than two-thirds of global fixed income investment volatilities. Again, this is because currency movements are typically more volatile than fixed income assets, which are supposed to be less volatile and provide a balance to equities in an investor’s portfolio.
On Endowus, we offer a diverse range of HKD-denominated Best-In-Class funds on our Fund Smart platform. One beautiful thing about working with globally leading fund managers is that we can outsource the hedging to the experts, as they can do FX risk management at their scale which is far more efficient and low-cost.
What about USD instruments, since USD-HKD are pegged
With the USD-HKD currency peg, many investors might deem purchasing US-listed investment products as the same as HKD denominated products. However, some might be surprised to know that for US ETFs, there is in fact a 30% dividend withholding tax which could really impact returns especially for high dividend-yielding instruments. Learn more here.
On the Endowus platform, we offer UCITS funds which are more tax efficient vehicles for Hong Kong investors compared to US-listed ETFs.
Working with a financial advisor to help you plan and manage your investment portfolio
At Endowus, it is our job to advise clients on how they can construct their portfolios, what instrument is most tax efficient and what to consider when managing currency exposure (hedged or unhedged).
As an independent non-commission based wealth advisor, our business model ensures that we are truly aligned with clients’ interests to help you reach your financial goals (and keep that foreign currency zip lock bag in your drawer tidy).
Spend a few minutes to open your account and start your investment journey with Endowus today. If you have any questions, feel free to connect with our SFC-licensed client advisors and schedule a free 1-on-1 consultation here.
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