Views expressed are those of the author and are subject to change. Other teams may hold different views and make different investment decisions. The value of your investment may become worth more or less than at the time of original investment.
- Driven by a growing domestic asset base and the desire for greater overseas diversification, many Australian investors have been allocating a larger percentage of their equity holdings to non-Australian equities.
- From a total portfolio diversification perspective, this trend highlights the increased importance to investors of both the behaviour of the Australian dollar (AUD) and the cross-correlations among foreign (non-Australian) equity markets.
- We have found that the risk-dampening impact of the AUD has drastically declined in recent years, from offsetting almost a third of portfolio volatility to effectively zero now.
- This loss has been partly made up for by the increased diversification provided by allocations across global equity markets, driven largely by Australian decorrelation, which has now become the predominant driver of equity portfolio diversification for Australian investors.
- In terms of investment implications, our findings suggest that some Australian investors might:
- Make greater use of currency-hedging techniques;
- Dissociate their currency exposure from their market-cap-driven equity allocations;
- Consider exposure to non-AUD currency crosses;
- Adjust their risk models to better reflect the new diversification regime;
- Put greater focus on the correlation structure among offshore assets;
- Look to add additional volatility-mitigating agents to their portfolios.
FOR PURE DIVERSIFICATION REASONS, many Australian asset owners invest offshore in various non-Australian assets, such as regional equity markets. The increasing size of Australia’s domestic asset base is also driving interest in international investing, as domestic investment pools are simply not large enough to absorb the substantial capital that needs to be invested.
From an overall portfolio perspective, investing in foreign assets, particularly equities, introduces two key diversification dynamics for Australian investors, both of which change over time:
- As the various international equity markets are imperfectly correlated with both Australian equities and with each other, offshore investing typically leads to a decrease in total portfolio volatility.
- Unless hedged, a non-domestic equity allocation includes exposure to the movement of the AUD, specifically its interaction with the returns from the underlying offshore asset classes, which could be either risk mitigating or risk additive1.
The purpose of this paper is to examine how these two changing dynamics affect the ability of overseas equity markets to help diversify Australian portfolios.
The changing impact of the AUD
Investing in non-domestic equities, by definition, involves exposure to the AUD. If unhedged, this exposure could be either risk additive (with the AUD weakening when foreign equity markets rally) or risk mitigating (with the AUD weakening when foreign equity markets weaken). Importantly, as equity market performance proxies a broader risk-off/risk-on cycle, these AUD relationships also mirror whether the AUD is…
To read more, please click the download link below.