Australian investors could be forgiven for avoiding global shares after a horrible decade of returns.
That would be a mistake.
International equities have an increasingly important defensive role for Australian portfolios with unhedged currency exposure. Now is not the time to give up on global shares as the United States economy recovers and currency movements favour local investors with offshore assets.
That is not to downplay the pain of owning global shares in the past decade. International equities were the worst-performing listed asset class between 2000 and 2009, losing an average 3.6 per cent each year, the latest Russell Investments/ASX Long-Term Investing Report shows.
Investing in cash returned an annualised 3.9 per cent. Over 20 years, international equities equalled the annualised cash rate return of 4.8 per cent. So make that two lost decades for investors after averaging returns.
Morningstar data shows global shares had the worst or second-worst annual performance of a listed asset class six times during the past decade.
Their best result in 2005 was third of seven asset classes (cash, Australian fixed interest, international fixed interest, Australian listed property, Australian equity, small caps, global shares).
The main culprit, of course, was the rising local currency, which squashed Australian-dollar returns from overseas investments.
Institutional investors who manage portfolios with unhedged currency exposure watched the rising Australian dollar against the US dollar erode gains in international shares.
Investors who bought global shares in anticipation of higher returns than local shares – as has generally been the case over long periods – were brutally reminded about currency effects on returns.
The stronger correlation between the Australian dollar and equity markets in recent years has changed international investing rules.
Typically, the Australian dollar rises when global sharemarkets rise, and vice versa.
Higher equity markets signal more risk appetite and therefore more demand for the Australian dollar, which is viewed as a risk currency due to its relationship with commodity prices.
Global sharemarket gains for Australian investors are dampened by a higher Australian dollar, just as global sharemarket falls are partly offset by a weaker Australian dollar, as was the case in May.
This correlation, if it continues, means portfolios with unhedged currency exposure have a natural hedge against falling global equities, in turn creating a more defensive element in equity allocations.
But it is arguable whether investors hold global shares with unhedged currency exposure for their defensive qualities. If so, it may make more sense to gain international equity allocation through lower-cost exchanged-traded funds (also unhedged against currency movements).
The danger, of course, is extrapolating past performance for any asset class and chasing returns, and assuming relationships between asset classes last forever.
The Australian dollar tumbled during the May global sharemarket correction but could easily recover losses when risk appetite returns and commodity prices rise again.
My view is parity between the Australian dollar and greenback is unlikely, and that we will see the Australian dollar at lower average prices than in recent years as the greenback strengthens due to its safe-haven status.
Also, the US economic recovery is gathering more momentum, notwithstanding poor job numbers in early June. On aggregate valuation measures, US equity markets look reasonably priced and may surprise on the upside as corporate earnings exceed forecasts. Asia remains strong, even with China cooling its economy to safeguard against a rising inflation threat.
Europe is a basket case, though a weak euro should at least boost earnings of European exporters to fast-growing Asian economies. Australia’s economy, still travelling better than most, has some serious challenges.
The federal government’s mining super profits tax has increased this country’s sovereign risk in the eyes of foreign investors, and a string of interest rate rises this year may have been too aggressive.
It is no surprise that Australian shares are underperforming several other western sharemarkets this year.
But the most compelling argument for unhedged global shares is their risk profile.
Morningstar data shows the standard deviation of global shares (measured by the MSCI World Index, ex-Australia, in A$) is lower than that for Australian shares (the S&P/ASX 300 index) over the past seven years.
Unhedged global equities also had lower standard deviations than hedged global equities.
Therefore, the case for international shares providing a better return/risk outcome than Australian shares this decade is improving. It would be unusual for global shares to turn into another shocking decade of returns, though anything is possible in such a volatile market.
Smart portfolio construction is about getting the best return/risk outcomes and appropriate diversification.
Many investors focus too much on potential returns and forget about risk.
They don’t work their portfolio risk budget hard enough. Improved returns from global shares with lower risk will boost overall portfolio efficiency this decade – and reverse some of the damage from a truly awful decade for international equities.
Tony Featherstone is the former managing editor of BRW and Shares magazines.
