PORTFOLIO POINT: The buying power of a strong Australian dollar makes it a good time for investors to consider adding some "global diversification" to their portfolios.

With many commentators starting to sound just a touch bearish about the Australian sharemarket, it is an interesting time to note that the Australian dollar is stronger than it has been in more than 17 years. Currently trading above US84¢, it provides greater strength in buying overseas assets than at any time since the Fraser Government was in power.

In other words, it might be time to think "global diversification" in portfolios, using the purchasing power of the strong dollar.

When you invest internationally, you are using Australian dollars to buy overseas assets, so you want the dollar to be as strong as possible, to maximise its purchasing power.

Conversely, when you are selling the assets or receiving income from them, you are turning overseas currency into Australian dollars - you want the Australian dollar to be as weak as possible to receive as many Australian dollars as you can.

For example, if you bought US investments with the Australian dollar at US84¢, if it fell to US75¢, your investment would have increased in value by 10%. Actually, it's just like shopping for imported goods. Those goods tend to get cheaper when the currency is strong as it is now, and more expensive when the currency is weaker. With the Australian dollar at US84¢ perhaps its time to go investment shopping overseas!

Why would you invest in global assets - shares and property - anyway? The main reason cited for investing in global shares is that the Australian stockmarket only makes up 2% of the value of the world's stockmarkets. My response to that is so what? Sure the Australian market is small, but why should that send people investing internationally?

The real answer is diversification. An argument regularly used against investing in overseas markets is that many Australian companies generate earnings offshore. And it's true that among the top 300 companies, many blue-chips now have up to 40% of earnings coming from offshore, so why take on further international exposure?

The answer is that even these companies earning money offshore are still listed on the Australian Stock Exchange and exist in the Australian economic and political climate. These are factors that result in the share price of such companies "reacting" similarly to other Australian companies, even if they do derive their earnings overseas. Of course, five years ago the environment for investing offshore was different to now: there was a weaker Australian dollar and more modest valuations in Australian shares.

The long run returns from investing in both Australian and international shares have been very similar. However, the returns don't come at the same time so there is an overall smoothing of the volatility in a portfolio.

To show this, let's go back to some historic data on sharemarket performance, showing the returns for the past 25 years. The Australian sharemarket returns are measured by the ASX All Ordinaries Accumulation Index and the international returns by the MSCI Word Index (total return, unhedged). The third column is the return from a portfolio invested in 50% Australian and 50% international. The red figures show whether the Australian or international shares have provided the stronger return.

 

nHow sharemarkets have performed
Year	Aust shares	Int'l shares	50% Aust 50% Int'l
1978	6.70%	6.20%	6.45%
1979	26.00%	17.20%	21.60%
1980	74.30%	11.50%	42.90%
1981	15.80%	13.00%	14.40%
1982	-29.00%	-4.00%	-16.50%
1983	34.70%	72.70%	53.70%
1984	13.50%	2.30%	7.90%
1985	36.50%	61.60%	49.05%
1986	42.50%	55.20%	48.85%
1987	54.00%	32.60%	43.30%
1988	-8.60%	-10.00%	-9.30%
1989	3.50%	18.10%	10.80%
1990	4.10%	1.90%	3.00%
1991	5.90%	-0.02%	2.94%
1992	13.30%	7.10%	10.20%
1993	9.90%	31.80%	20.85%
1994	18.50%	0.00%	9.25%
1995	5.70%	14.20%	9.95%
1996	15.80%	6.70%	11.25%
1997	26.60%	28.80%	27.70%
1998	1.60%	42.20%	21.90%
1999	15.30%	8.20%	11.75%
2000	13.70%	23.80%	18.75%
2001	8.80%	-6.00%	1.40%
2002	-4.50%	-23.50%	-14.00%
Avge	16.18%	16.46%	16.32%
Std Dev.	20.91%	22.95%	19.13%

Figures in red gave stronger return

I have gone back to the period before the current five year rise of the Australian dollar, and I've used the 25 years of data prior to that time.

The next graph is all-important. It shows the value of $10,000 invested in either Australian shares, international shares, or a portfolio made up of 50% Australian and 50% international shares. You will note that the portfolio made up of 50% Australian shares and 50% international shares is actually worth nearly $30,000 or 10% more than the investment in just Australian or international shares. This does not seem to make sense - the average return for the 50:50 portfolio is LESS than for international shares. How can it have a higher ending value?

The answer lies in the volatility of returns, measured by the standard deviation of the portfolio. With a standard deviation of 19.13%, the 50:50 portfolio is less volatile, leading to an increased compounding of returns.

As an example of this consider two $100,000 portfolios, one with annual returns of 10% in the first year and 10% in the second year; the other with annual returns of 20% and 0%. Both have the same average return of 10%, however the one with 10% return each year, which means less portfolio volatility, will have compounded to a value of $121,000. The other will only be valued at $120,000.

nA satisfying blend

It's worth noting two points here: First, the sheer power of capital markets to provide strong investment returns over time - $10,000 into nearly $300,000 in 25 years for just investing in the average market return with a buy and hold strategy is extraordinary. Second, the reason I chose 25 years is because most people looking to retire at between ages 55 and 65 may well have retirements much longer than 25 years and can't afford to ignore the importance of having growth assets in their portfolio to producing strong long-term investment returns.

But global returns have been poor

As at the end of February 2007 the seven-year return for the MSCI World Index (dividends re-invested) was 1.73% a year. That's a terrible return; why would you invest in that asset class when cash is returning 6% or more?

Most of the poor performance from international shares has been due to currency movements. If you take out the currency movements, global sharemarkets have actually returned 10.45% a year over that same period.

Moreover, there is no reason to think that going forward global sharemarkets will not provide reasonable long-term investment returns. Indeed, the very reason that five-year returns have been generally poor - the rising Australian dollar - now provides an opportunity to use this strong Australian dollar and invest in international assets.

How to invest globally

While there are quickly expanding opportunities to invest directly in international shares through Australian brokers and online brokers, the reality is that most people still choose a managed fund approach to accessing international shares. Their reasoning is generally that it is difficult to have access to the research to understand and trade companies in foreign markets.

Keep in mind that if you do want to invest directly in overseas firms, it can be done through the majority of brokers but you will generally pay a higher rate of brokerage for this access. In assessing this option, and indeed all global investments, keep in mind that the income paid from overseas shares will not have the benefit of franking credits.

The other way of investing is through managed investments, with the options being an "active approach" through a managed fund, or a lower-cost index fund.

Here is an interesting twist on the index fund idea. Most Australian brokers now give access to overseas sharemarkets. Rather than invest in an Australian index fund, you could investigate using an exchange-traded fund listed on an overseas market. These are stock exchange-listed investments that mirror an index return, usually at a very low management costs, especially when compared to Australian funds.

Australia has some international fund managers that have been outstandingly successful. Kerr Nielson's Platinum Asset Management is about to float for about $3 billion, while the smaller Hunter Hall's Value Growth Trust, managed by Peter Hall, has an impressive 10-year compound return of 19.2% a year. If you choose to take an active approach though an active fund manager such as Platinum or Hunter Hall, always be aware of the fees you are paying. Also keep in mind that there are some very good, low-cost listed investment companies that invest in global shares. These are well worth considering. The ASX website has a spreadsheet with data about available listed investment companies.

Hedged or unhedged?

There are two ways to invest in overseas assets. One is to use a currency hedged fund, where currency movements are taken out of the equation for returns and returns simply come from the movements in the overseas investments.

An unhedged fund leaves you exposed to gains and losses from both the market return and the currency return.

Over the long term, the decision whether to hedge currency risk or not does become less important. Unlike investment returns, which can continue to build over time, the currency effect is limited to the range that the currencies trade in - and so its effect over longer time frames becomes less important. Of course, it does not have to be an "all or nothing" decision. Many fund managers use partial hedging and you may choose to have some hedged investments and some unhedged.

If your opinion is that the dollar is at the top of its likely valuation range, and certainly the 17-year highs might indicate that, then an unhedged approach will help you pick up additional returns if the dollar falls.

Conclusion

In the long term there is a diversification story in holding some international investments as part of your portfolio. Short term, the Australian dollar is at 17-year record highs. International shares are well worth a look now.