Risk, risk and more risk. Where there's an investment there's always risk. Sometimes investors don't even know what that risk is. Foreign exchange risk is one that is little understood by the average investor.
It works like this. You've bought an investment in another currency and that currency falls in value or the New Zealand dollar rises. Suddenly the investment is worth less than you paid for it simply because of the exchange rate movement.
Currency fluctuations can cause a nasty shock - especially when your home currency is volatile, as the New Zealand dollar is. In the past five years the New Zealand dollar has ranged from 55c to over 87c against the US dollar - which is a huge variance.
It's a paper loss. That is unless you need to convert the money back to New Zealand dollars. Tell that to an investor who has just lost 15 per cent of the value of his or her portfolio, however.
The trouble is investors often fail to consider currency risk. Jeffrey Stangl of Massey University's school of economics and finance has trouble getting even his masters students not to glaze over when the subject is raised. It's no wonder private investors are so ill informed.
To explain currency risk Stangl cites the example of an investment in IBM. The shares may go up in value, but if the United States dollar weakens and the New Zealand dollar rises the investor here may see no gain or even a loss. A lot of investors have seen this happen in the past few years.
Currency is an additional dimension of risk that investors get when they invest in overseas markets, whether they buy those investments through a New Zealand-based managed fund (more about that later) or they invest directly by buying shares, bonds or other investments in another country.
Investors in managed funds often have the foreign exchange risk taken care of for them. Managers hedge the currency risk by a number of methods. One of the more common methods, according to Morningstar, is by entering currency swap agreements. Two parties quite simply swap a pair of currencies.
KiwiSaver funds, which may have overseas equities, property and fixed interest in them, use hedging fairly extensively. The last thing the KiwiSaver manager wants is customers seeing a 20 per cent or 30 per cent drop in the apparent value of their investments, solely because the exchange rate has moved.
For that reason KiwiSaver funds tend to be more aggressive about hedging than some other funds aimed at more experienced investors.
Investors in KiwiSaver can be less financially savvy than managers' other customers who have made a conscious decision to invest in funds.
Even though currency losses are likely to even out over the long run, customers can freak out when they see a negative number on their annual statement. Ironically hedging costs money, which will ultimately affect the fund's bottom line and will lessen the return.
Typically, says Chris Douglas, Morningstar's co-head of fund research, KiwiSaver managers hedge 100 per cent of their overseas fixed interest and property investments to smooth out potential shocks. These are the defensive part of their portfolios. With their overseas equities, KiwiSaver providers' long-term hedging ratios range from 50 per cent to 100 per cent.
Morningstar found that, for example, the long-term hedging ratios for ASB KiwiSaver is 50 per cent for international equities, 70 per cent for Australian equities and 100 per cent for both international fixed interest investments and property.
In the short term the managers may vary from these percentages, says Douglas. For example, when the New Zealand dollar is high as at present, it's likely some KiwiSaver providers have lowered their short-term hedges. They figure should the kiwi dollar fall the value of the overseas holdings will increase as a result. For example, says Douglas, Mercer and some other KiwiSaver providers have decreased their currency hedging to less than 50 per cent.
A 50 per cent hedge could be viewed as a dollar each way, says Robert Oddy, financial adviser at International Financial Planners. Or if you want to take the risk yourself some funds such as those from boutique investment company Diversified are completely unhedged. DIY investors can invest in three unhedged funds through RaboDirect. co.nz. Those funds from AMP Capital are the Core Global Shares Fund, Emerging Markets Share Fund and Emerging Markets - UT65 Fund.
With unhedged funds, if you buy when the dollar is high and sell when it's low - and the fund's underlying value has risen at the same time - you're a winner twice. Of course, the opposite can also be true.
Unhedged investments have some diversification benefits. Sometimes investors gamble that history will repeat itself and the New Zealand dollar will eventually revert to the mean, which could be lower than the US85c it has been trading at recently.
Beware, however, says Oddy.
"Anyone who tries to gamble on currency movements is extremely brave in the short term or they are very keen on a little bit of an adrenaline surge."
It's almost impossible for Joe Bloggs to manage his own currency risk for a small portfolio, says Stangl. They don't have access to or the money to pay for the tools large organisations such as AMP or Fonterra can afford. In theory, says Stangl, you could buy a bundle of shares in another market and take out a loan in the same currency, but most people wouldn't.
The other option - keeping all your investments in one country such as New Zealand - isn't necessarily a good idea. The risk is that the New Zealand economy tanks and your investments all fall in value. Diversification includes spreading your money around the four corners of the globe.
The International Monetary Fund reckons our dollar is overvalued by between 5 and 15 per cent.
There are times when investment decisions may be swayed by the underlying currency, says Stangl. If, for example, you have two otherwise equal investments, one in US dollars and the other in euros, the comparative volatility of those currencies is going to be an important factor in the investing decision.
Investors in unhedged funds need long time horizons. If you need the money converted back into New Zealand dollars in the next few years, don't do it, Oddy says.
It's not a worry, of course, if you don't need to bring the money back to New Zealand. You might be able to hold on and time the sale for when both the currency and stock market gods are in alignment.
Although I talk mainly about funds, individual equities are unhedged. So if you buy Facebook, Microsoft, Google or any of those highly sought after multinational companies directly there is no currency hedging. At the moment, says Douglas, such global shares are relatively cheap for Kiwis thanks to the high dollar.
Investors also need to beware of hidden foreign exchange risk, says Stangl - especially with precious metals. Although you might buy these metals in New Zealand dollars, the metals trade in US dollars. So there is a hidden currency risk.
He cites the case of a friend who he failed to convince over a barbecue to be careful. The friend bought hundreds of thousands of dollars of gold just before the price dropped. If that wasn't bad enough, the New Zealand dollar appreciated at the same time, amplifying the loss.
"Even my dear friend, who is a successful businessman, failed to appreciate that hidden risk."
Stangl, a US expat with investments both here and in his native country, found himself going grey with worry about the volatile exchange rate. He decided to invest half his capital here and half in the US. It is a tool other expats can use as well, but is not so easy for someone who values their wealth solely in New Zealand dollars.