Over the last few years, the question about which currency we should invest has been raised regularly. There are plenty of currencies circulating in the world but as a point of reference let’s take Indian rupee. As you probably know, metals and commodities are denominated in USD, as are ETFs on shares from many countries. Companies like Gazprom can be bought in ruble, euro or dollar. In what currency, then, we should make transactions? Does the currency in which the asset is denominated have any meaning for us?
Well, in the vast majority of cases no. When buying gold, we are interested in the price in INR. When buying Russian shares, we have actual exposure to shares and to rubble to rupee relation. It doesn’t matter if we buy shares denominated in EUR, USD or RUB. In some cases, currency has some meaning, so I have divided transactions into several types that will help you understand when the currency in which an asset is denominated matters and when not.
It is important because in the coming months I expect sharp turmoil and further strengthening of safe haven currencies like USD or CHF. Over time however, when central banks will sharply lower interest rates and launch unlimited printing, the time will come for purchases. Over 85% of assets are denominated in USD and I make almost all investments in this currency. However, if central banks after a few months of turmoil buy peace again, another bull market will be very similar to that of 2003-2008.
Considering the 16-year cycles on the dollar, the migration of capital to emerging markets and to commodities, it is very likely that after reaching the peak U.S. dollar will gradually get weaker, as it happened in 2002 – 2008. That time, the dollar fell from 49 rupees to less than 40 rupees (18% drop). Is it possible to lower the exchange rate to around INR 59 (18% drop from current 72) in the long run?
In my opinion, such a strong sell-off of the dollar against the rupee is very unlikely, but not impossible. On the other hand, I think that the fall of dollar value is almost certain over the next few years. Therefore, in some cases we should protect ourselves against such a scenario. In this case, the most useful is forex on which we bet on increase or decrease of a given currency. For example, buying a contract for the INRUSD currency pair we gain when the rupee appreciates against the dollar. Thus, if we have investments only in dollar assets, what we lose on the dollar weakening against the rupee, we gain on the INRUSD futures contract. Here, let us understand each other clearly: by forex, I understand some hedging of our investment against exchange rate fluctuations. No leverage, no speculation. Pure protection and this is only in some particular cases.
Now I have to go into some details because very often there are misunderstandings as to when we are actually have exposure to the dollar and when we don’t.
a) Precious metals
Let’s assume for the sake of discussion that we are buying ETF for gold. We have a choice of three funds denominated in USD, EUR or CHF. From the investor’s point of view, does the choice of currency matter? Absolutely not. Many people intuitively choose CHF, considering the franc the safest currency. Meanwhile, it does not matter, because we buy gold and we have exposure to gold.
To allow you to understand easier, I will go back to January 15, 2015, when the Swiss Central Bank stopped defending peg on franc. In one day, franc went up by 15%. Have we earned this 15% with ETF for gold denominated in CHF? No, because the strengthening of the Swiss currency meant that the price of gold expressed in CHF fell exactly as much as the franc strengthened. The price of funds denominated in USD or EUR practically has not changed. When buying ETF for gold, silver or commodities, we ensure exposure to the asset, not the currency in which the contract or ETF is denominated. Therefore, when investing in commodities or precious metals, we do not need a hedge on currencies.
On the other hand, precious metals and commodities grow the most when dollar become cheaper. With these assets in your portfolio, you assume a scenario where dollar price of assets will most likely increase, but at the same time the dollar exchange rate against the rupee will decrease. You can theoretically consider an INRUSD contract to offset the effect of a cheaper dollar. However, it is a double-edged sword. If everything goes your way, that’s fine. However, if for some time we will have a bear market on commodities and bull market on dollar, then our portfolio will be double hit.
b) Dollar ETFs on shares from developing countries
In the case of funds that give us exposure to shares from a given country, the currency where the ETF is denominated does not matter, as it is the case with commodities. When buying, for example, RSXJ (small Russian companies), from the Indian investor’s point of view, two things are important: share price and ruble exchange rate in relation to rupee. The dollar exchange rate in which the ETF is denominated does not matter to us. Imagine a situation where we have two funds. The first is RSXJ denominated in USD, the second one invests in the same companies, but the fund price is given in INR.
We have a bull market on the Moscow Stock Exchange. At the same time, the dollar is becoming cheaper in relation to both the rupee and the ruble. RSXJ prices in USD are growing 40%. At the same time, the dollar is cheaper to rupee by 10%. Effect? Our investment in INR will give us a 26% return (1.4 x 0.9). Exactly as much as fund of Russian shares denominated in the Indian currency would increase.
From the investor’s point of view, where the most important thing is the return in INR, it does not matter whether he buys a fund for shares from a given country denominated in USD, EUR or any other currency. Securing a futures contract in this case does not make sense, unless it is a INR/RUB contract.
If you own shares from Pakistan, Turkey or Nigeria, then your result is affected by the change in share prices in these countries and the rate of the local currency in relation to the rupee. However, given that in the next cycle we will strongly invest capital in the shares of developing countries, change in the exchange rate of these countries will be very similar to what will happen to the Indian currency. In other words, if the dollar becomes cheaper by 30-40% in relation to the currencies from countries listed above, it is likely to become cheaper to a similar extent in relation to the rupee.
An example of an ETF for Nigeria will increase in USD by 100%, which will result in a 60% increase in Nigeria stock prices and a 40% strengthening of the Nigerian currency against the dollar. Will our profit in INR be 100%? No. It will fluctuate around 60% because we will lose 40% of the 100% price increase in USD on the strengthening of the Indian currency against the dollar in which the fund’s quotations will be expressed.
c) American shares
Over the recent years, investment in US shares has paid off twice. First of all, the prices have been rising like crazy. Secondly, the dollar in which they were denominated has been rising. Therefore, the Indian investor made money on both. With current valuations as well as the USDINR exchange rate, buying American companies makes no sense. However, if valuations would decrease by 30-40% over time, one might consider investing some capital in small value companies. In this case, hedge with 100% capital makes sense. We invest in companies located strictly in the country, whose currency will probably weaken against the rupee. Buying ETFs for American value companies for say 50,000 USD with a high probability in parallel I would open a long position on INRUSD for the same amount, completely offsetting the change in the dollar.
Remember, however, that such a move significantly increases the volatility of our investment. Suppose our ETF increases 25% in USD in a good year. In parallel, the dollar will weaken against the rupee by 10%. Our profit is therefore 12.5% (1.25 x 0.9). If we hedge our position, we will earn 25% in an optimistic scenario. However, if we hit the worst year period, which in the perspective of the whole cycle is almost certain, we can lose twice. Let’s assume that our shares have become cheaper by 20%. At the same time, the dollar strengthened by 10%. Our total loss will be 30% (20% shares and 10% on the currency pair). The dollar in case of U.S. shares and commodities plays a role of limiting volatility.
d) Commodity funds
The situation is different in the case of commodities funds. I analyzed ETF PICK investing in companies extracting and processing industrial raw materials. According to the geographical structure, 26% of companies are from the UK, 20% from Australia, 10% from the U.S., 7% are in Japan and Brazil, 3-4% in Russia, Canada and South Korea. Is that telling us something? Is this useful information allowing us to assess whether a hedge is necessary? In my opinion no. The two largest companies in the portfolio are BHP Biliton and Rio Tinto. It is irrelevant on which stock exchange and in which currency this company is listed. For example, RIO and BHP shares are listed in London, Sydney and New York. Both companies have numerous mining projects around the world, some in developing countries and some in developed ones. Increase in commodity prices translates into higher wage costs in countries such as Australia or Canada, whose currencies are strengthening along with commodity prices. In addition, the cheaper dollar means higher energy prices, which in some cases represent 50% of the cost of mining the commodity. In my opinion, in this case we are dealing with so many variables that the decision on whether to hedge our ETF investment denominated in USD on Forex should depend only on the volatility we accept.
I will explain it in the following example of a similar ETF ticker: XME (Metals & Mining) with a much longer history than PICK.
At the top of the bubble in commodities in 2008, this ETF cost 95 USD. At that time the dollar was around INR 40. Let us assume, therefore, that one unit of the fund cost INR 3800. Currently, after years of market downturn in commodities, this fund costs 25 USD, but we have a dollar of INR 71, so the rupee price of ETF is INR 1775. Over the decade, in dollar terms, the fund lost almost 75%, in rupee “only” 53%. strengthening of the dollar worked like a shock absorber.
Let’s reverse the situation now. If the prices within a few years returned to those from 2008, our investment would bring 114% profit if we did not hedge against the fall of the dollar exchange rate and 280% if we would hedge the entire investment at the current rate. Greater profit is tempting, but greater potential is associated with higher price fluctuations, which can be very strong especially in the case of commodities ETFs. As for me, in this case it is impossible to say clearly whether to hedge such an investment or not.
e) Sector funds
Another example is the fund for individual sectors. I will describe it using the example of ETF providing exposure to car manufacturing companies. Namely, the CARZ fund is denominated in USD. However, its portfolio contains 32% Japanese companies, 27% from the Euro Zone (mainly German), 24% from the U.S. and 16% in shares of Asian companies (excluding Japan). This is the key. If we wanted to properly hedge against exchange rate fluctuations, we should open the positions in appropriate proportions for INRJPY, INREUR, INRUSD etc. Whether this fund is denominated in USD, CHF or EUR is not important. Let us assume, however, that inflation is exploding in Japan. During the year, the yen loses 30% to the dollar. With high probability, the prices will increase more or less as much as the yen lost. By securing ourselves against the fluctuations of the Japanese currency, we would earn extra on forex, but in my opinion, this type of activity goes far beyond investing based on finding cheap assets and it’s rather becoming currencies speculation.
With a portfolio that includes a variety of asset groups with different specifics and geographical breakdown, you can’t perfectly hedge against currency fluctuations. We have to accept them and that’s it. While I am for 100% hedge when investing in U.S. companies, in other cases I have very mixed feelings.
I am certainly against securing ETFs on gold or silver. We should also not hedge dollar shares funds from developing countries whose currencies are much more correlated with the Indian rupee than with the U.S. dollar. There is some hedge to think about in the case of commodities companies. Maybe at 50% of the investment value, but only for people who are able to accept much greater volatility.
Finally, I would like to highlight one more thing. After a period of turmoil in the financial markets there will probably come a few years when the dollar will start to weaken. At the same time, prices of precious metals, commodities and shares will be rising in developing countries. The prices of metals and commodities are denominated in USD. It can be assumed that a 20-30% price increase translates at the same time into a 10% decrease in the dollar exchange rate in relation to INR. If we really want to reduce the effect of weakening the dollar and get as much as possible from the investment, we can secure it with 100% hedge. First, it will increase the potential for profit. Secondly, it will significantly increase portfolio volatility. Thirdly, the large hedge position on INRUSD will become a position itself that can both increase our profits and potential temporary losses. All this can cause extreme emotions, and these are known to be the worst of advisers.