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 Singapore 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 SGD 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?
Firstly, for those not in the know, currency exposure is term referring to the vulnerability of an investment, cash flow or financial position to variations in the exchange rate of two currencies. 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 $5.1 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. Put another way, there is no beta associated with it, and active currency management is one of the pure sources of alpha (transportable alpha), therefore attracting the attention of many investors.
Let’s start with the premise that we can’t forecast where exchange rates will be over the next few years - they may move in our favour, or they may not.
But what we do know is that there are diversification benefits of investing globally and moving away from a home country bias.
Stocks outside your home market tend to have broader exposure to economic and market forces compared to domestic stocks. 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.
Currency itself has no intrinsic return profile. Unlike a bond, it has no yield or coupon. Unlike a stock, it has no earnings growth. Currency reflects a country’s inflation, interest rates, government policies, and the market’s supply and demand to participate in businesses using that currency. Currency exposure, when sufficiently diversified across currencies, adds to the return volatility of an investment portfolio but has little impact on the portfolio’s total expected return.
In a report on portfolio currency hedging, Vanguard concluded that currency exposure increases volatility in the short-term, but over the long-term, it will have a minor fluctuating impact on the portfolio’s total expected returns.
Currencies can add additional sources of volatility but also diversification to your portfolio. During a market crisis, markets can all crash in tandem but currencies cannot all depreciate simultaneously (all exchange rates are relative). At the end of the day, we think that having a portfolio (drawer) of diversified currencies isn’t a bad thing, it’s more important to manage your overall allocation and purposefully keep your drawer organized.
At Endowus, the importance of currencies is focused on its role in asset-liability matching.
Singapore-based investors own Singapore dollars - you have assets (savings & investments) in SGD and liabilities (current & future spending needs) in SGD. Therefore it creates a needless additional layer of risk (FX volatility risk) to your portfolio by buying overseas assets that are not hedged back to your local currency of SGD, especially in fixed income, which you own because of its lower risk and volatility compared to equities.
We chose not to invest in overseas assets such as USD denominated ETFs from Singapore, because in addition to the multi-layered costs involved and unnecessary dividend withholding tax, there is this additional layer of unnecessary FX risk.
We have made a conscious decision to hedge the bond allocations in our portfolios. We are not taking a bet on currency. We are simply acknowledging the fact that the expected absolute return on bonds is lower and therefore, as you spend money in your local “home” currency, you want to maintain the purchasing power and be compensated for your risk-taking in your “home” currency, regardless of whether your “home” currency goes up or down.
As Vanguard has shown, currency volatility plays less of a role for international equities, but greatly changes the volatility characteristics of your fixed-income exposure if left unhedged.
One beautiful thing about working with globally leading asset managers is that we can outsource the hedging to the experts, as they can hedge currency exposures in a far more efficient and low-cost manner given their scale.