With the global financial crisis and Europe’s sovereign debt problems, volatility in global financial markets has picked up in recent years. It begs the question: how can risk-seeking investors best exploit such volatility, or risk-averse investors protect their portfolios?
In other words, which investments on the Australian market provide the most aggressive and defensive opportunities?
As is usual, I’ll concentrate on the opportunities in the exchange-traded funds (ETFs) area, which now enable investors to tap into a variety of international markets and sectors.
Let’s start with defensive investments – or those that are likely to fall by less, or even potentially gain in value should overall Australian market conditions deteriorate. In this regard, holding defensive investments can greatly help diversify one’s portfolio, and help protect the downside in times of trouble.
It may surprise some to know that – thanks to the general pro-cycle behaviour of the Australian dollar – most international equity markets offer useful defensive properties.
To date, all international equity ETFs available on the Australian market are valued in Aussie-dollar terms, or unhedged, meaning you take on the currency risk of the offshore market one invests in. If you invest in the iShare’s S&P 500 ETF (ASX code IVV), for example, you not only have exposure to America’s S&P 500 index but the bilateral exchange rate between the Aussie and US dollars. As has been evident in the past two years, if the Aussie dollar rises relative to the greenback, it reduces the Aussie-dollar value of your US ETF investment – and vice versa.
As in recent years, the Aussie has tended to rise when global equity markets are rising – and the reverse is also true – so the effect has been to dampen the volatility of Aussie-dollar returns, as through an unhedged ETF, when investing offshore.
For example, between 2003 and 2011, the standard deviation of annual price returns for the S&P 500 index in US-dollar terms was 19%. Yet in Australian-dollar terms, the standard deviation in S&P 500 returns was only 9%.
Over this period, every 1% annual price change in the S&P/ASX 200 index has tended to be associated with a 0.3% gain in Aussie-dollar terms for the S&P 500 index – in other words, the S&P 500 has a ‘beta’ of only 0.3 against the Australian market.
But there have been even better defensive investments than the S&P 500 index. The beta for Australian-dollar gold returns (ASX:GOLD) over this period was minus 0.3, which means the gold price in Aussie dollars tended to rise by 0.3% for every 1% fall in the S&P/ASX 200 index. And it’s now also possible to hedge currency risk when investing in gold through another ETF (ASX:QAU) – and even on this basis the correlation with the Australian market in recent years has been fairly low.
iShares also offers (unhedged) ETFs in relatively defensive global sectors such as healthcare, telecommunications and consumer staples. Again, the correlation in returns between these sectors and the Australian market in recent years has been fairly low.
To my mind, while gold has been a good defensive play in recent years, valuations for the precious metal are now so high that there’s a risk of a significant price correction over the next few years – undermining its defensive qualities. If you’re looking for defence at reasonable value, the iShare’s S&P Global consumer staples may be the ticket (ASX:IXI).
For those wanting to chase the upside, probably the more aggressive plays would be in emerging markets (ASX:IEM), or even narrower BRICc ETF (ASX:IBK) covering just Brazil, Russia, India and China. Between 2003 and 2011, the betas for IEM and IBK against the Australian market were a reasonably high 1.2 and 1.5 respectively. Local resource sector ETFs (RSR, QRE or MAM) also enjoyed high betas and offer similar upside potential if the commodity boom returns in earnest.
But, if you really want to chase risk, you really can’t go past China itself, through iShares ETF (ASX:IZZ). China’s stock market has gone nowhere in recent years and is now quite cheap by historic standards. With China’s economy cooling and policy makers inching toward an easing in tight credit policies, China’s stock market may be poised to take off once more – especially if local Chinese investors redirect their speculative energies from the overheated property market to the long neglected equity market.
Important information: This content has been prepared without taking account of the objectives, financial situation or needs of any particular individual. It does not constitute formal advice. For this reason, any individual should, before acting, consider the appropriateness of the information, having regard to the individual’s objectives, financial situation and needs and, if necessary, seek appropriate professional advice.
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- Ron Bewley: Portfolio building: diversification with cash
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