Taking advantage of extreme foreign exchange rates

As I write this post, the Australian dollar is back close to all time highs against the USD ($1.0804), it has reached 27 year highs against the GBP (0.6795) and is at all time highs against the Euro (0.8147).

I have previously posted that a good way to take advantage of this is to invest in undervalued foreign indexes / stocks when your home exchange rate is high so you get the double benefit of a recovery in the stock price and the benefit of downside protection due to an expected improvement in the currency (note that this protection is over the long term).

The problem I am currently facing is that stocks had their best start to the year in a decade in January in almost all markets. This means that the case for investing in those stock markets on their own merit is not as strong as it otherwise would have been. I have been looking at other products to see if the idea can be replicated. Interest rate products in the US / UK and Europe are not attractive to Australian investors currently as their low yields (1 - 3%) are far below what could be achieved by investing in Australian bank stocks (6 - 8%).

An alternative I looked into was also buying and holding foreign currency. The opportunity cost of this money however is the interest / dividend yield I could be earning while invested in other products. Options offer an attractive way to gain exposure at a lower cost however their costs tend to be very high and as they are OTC products making a small investment to 'test the waters' does not appear possible.

I am leaning towards putting my money into a German micro cap stock that I believe in as the stock is not affected by European woes (Chinese based company listed in Germany). The exchange rate for the Euro is outrageous and if the Eurozone was to come up with a solution for their current woes the currency would immediately snap back.

Expenditure tracker - January

As I outlined in my new years financial goals I was going to track my expenditure over the year and see whether I have been keeping in line with my expenditure goals. As a reminder my targets were

• $3,300 per month increase in my share investments


• $1,600 per month increase in my loan offset account (net of interest costs)


• $1,500 per month allowable personal expenditure

As I mentioned in my January net worth post, I found controlling my personal expenditure the hardest. My performance is listed below along with my over / under performance of my relevant targets

• Share investments: +$5,000 ($1,700 over)


• Home loan offset account: -$300 ($1,900 under)


• Personal expenditure: $2,700 ($1,200 over)

I was relatively happy with my combined investment performance. Effectively I was only $200 below my target and this will balance out in the coming month as I allocate money to my offset account and not to my share investments.

The part that I found most difficult (as evidenced above) was personal expenditure. The problem that I have when I look at my performance is that I know in the next month I am going to increase this deficit as my credit card bill for February has already come through and it is not an improved situation.

I suspect that I've underestimated my own cost of living (i.e. I can probably live on $1,500 a month but I'm not sure that I want to) and will continue to evaluate over the coming months whether this is an unrealistic objective.

January 2012 Net Worth - $212,000 (+2%)

Assets: $568,000 (+1%)
Liabilities: $356,000 (+0.5%)
Net Worth: $214,000 (+2%)

For the first time, the net worth increase this month was driven by positive share market returns. The return was offset by significant personal expenditure from Christmas coming through in January.

Assets and liabilities for the month were driven by

• A significant return on one stock investment. The stock was bought significantly below book value and has been the subject of takeover rumours throughout January. I have not sold any of this stock yet as it is still below what I think fair value for the stock is. I will devote a longer post to this later but I am constantly amazed at how a single outstanding return can improve the return of a portfolio with lots of small losses in it


• Much lower levels of cash - much of it spent over Christmas and significant expenditures due in January. I expect this to continue into February as several large bills fall due though to decrease once again in March


• My credit card balance doubled over the month however the shape of my expenditure means that payment of the bills will not all hit in February - some of the expenditure will be spread to March as well

My predictions for the next month include:

• In the next month I will update my superannuation (retirement account) balances which should increase my assets significantly. I have been trying to find a way to do this on a monthly basis however statements are not updated on that regular a basis.


• I also expect my disposable income to decrease by 10% next month as my employee share incentive plan kicks in. This, however should not impact by net worth to as I will reduce my investment expenditure to account for this.

Car insurance: Discount or regular insurance

In my previous post on getting a great deal on car insurance I mentioned that I only considered the regular / full price (or expensive) car insurance and did not really consider discount car insurance due to the peace of mind that comes with a large reputable insurer.

However, on later reflection, and as I posted more about the benefits of a discount broker (Interactive Brokers) I thought I would investigate to see whether a discount car insurer could offer the same value as a discount broker. I accepted the fact that for the lower price you don't get all the frills however I set out to see whether it was worth it. A couple of background facts about my situation: I own my own car, I have no loan on it, I live in a suburb which attracts a relatively high car insurance premium and I have never had an 'at fault' claim in ~8 years of driving.

The full service insurers were offering me insurance premiums ranging from $1,100 to $3,000. The discount insurers were significantly cheap and for the same level of cover were offering premiums of between $600 - $800. There were several traps however:

• Some insurers (such as Bingle) make you pay the excess whenever you claim (and not only when you are at fault. This means that you're paying the ~$700 premium and even if you do nothing wrong you have to fork out an extra $400 - $600



• Other insurers are new and trying to gain market share (e.g. Progressive Direct, a subsidiary of US insurer Progressive, is offering really cheap rates in order to gain market share in Australia). Their PDS looks great and they look like they are offering the same service as the big insurers for a much lower price. Ordinarily this is exactly what I'd be looking for.

The reason I didn't go with Progressive Direct is that I have no idea what they are like when you claim. With most insurers all you need to do is google for product reviews and you get a general idea what they are like on claims. Some have relatively good reputations (e.g. GIO, AAMI) and others tend to get ripped to shreds by consumers (e.g. Bingle). You do not get the ability to look up what a new insurer is like and so are taking a risk that they will not pay out which makes your insurance premium meaningless.


The reason I ended up sticking with the full service insurer is peace of mind. The more I looked into it the more I realised the comparison with discount brokers was not warranted. With a discount broker you are getting the discount for your own research and financial savvy. With a discount insurer you are paying less because you take on the risk that they will refuse to pay out for an unexpected / unforeseen reason or that they stick you with costs you do not expect. In the insurance case you have no control over the company's policies and whether they will pay out so what you are paying for with a full service broker is a reputation for fair dealing.

Benefits and traps of a Corporate Credit Card

Given that I have had the benefit of a corporate credit card (and having been recently bitten by that same card) I thought I would give an overview of good ways to use them - and how to personally benefit from a corporate card.

Corporate cards are normally given to employees who regularly have corporate expenditures to avoid the hassle of cash reimbursements. Run of the mill expenses that these cover include taxi's home (for those who often work late), meal budgets (again for those who work late) and corporate event expenditure for those who are responsible for booking / paying for these events.

My experience was with the American Express corporate card. The way the system worked at my previous employers was that I would incur expenses on the card, keep the receipts along with client charge codes for those receipts. Once a month my personal assistant would then take my receipts and put them through the system and I would get reimbursed about 2 weeks before the bill was due so I could pay it. The reason the company didn't pay the card off itself was that if they did not approve of the expenditure then they would not reimburse you for it and you had to pay for it personally. My normally expenditure in a month ranged from $2000 - $3000.

There were two big benefits to using the card (if you did it properly)

1. I could use the points that accrued on the card for personal purposes. Although this does seem like a rather minor point, I ended up getting about $250 - $500 worth of gift vouchers every year from the system which was essentially free money


2. I did not pay off the account as soon as I received the cash. As the reimbursement was typically deposited in my account 2 weeks before the bill was due, I would transfer this amount to my offset facility for my home loan and therefore pay less interest. Again this amount may seem trivial but it cost me nothing and I would save !~$100 per year in interest. This sort of return associated with any sort of risk or if it required any of my own capital is totally not worth it but given that it wasn't my money and it cost me nothing it was a no brainer.

I used the above system effectively for the last 3 years at my previous employer. The problem arose when I switched employers. My corporate credit card was cancelled in October when I left however in December I received an overdue notice from Amex for charges (relatively minor) incurred in December. I tried to sort it out with my previous employer but they are not that helpful given I am no longer an employee there. I then tried to find out from the vendor what the charges were for however given they were taxi charges the business owner was on leave for the Christmas holidays.

Under normal circumstances I would have paid the bill and tried to sort out the issue later. The problem is that when vendors refund credit card charges, they refund them to the card they were charged against which in my case has been closed already. In the meanwhile late charges etc. build up and American Express has been remarkably unhelpful. I think I will end up just paying the amount so that it does not affect my credit rating too badly but for all those with corporate cards you need to keep in mind that this may happen.

Foreign index funds: An example

Continuing on from yesterdays post, I thought I would walk through an example of an investment I recently made in the FTSE100 index.

Rationale

The rationale for my investment was twofold

1. The UK market has been depressed for sometime now. This is the type of market I like to invest in as people are so scared of risk, if you are risk neutral (or less risk averse than most as I am) then this is the perfect type of market. I also tend to be a contrarian personality wise and am much more comfortable investing in the market when others are not (note this probably comes from losing half of my investments as I began my investing career just prior to the GFC)


2. The AUDGBP is at close to its highest rate ever in AUD terms. It is overvalued against almost every other currency. Now to be clear all I'm doing is making the bet that there will be some sort of reversion to a normal exchange rate. I'm not saying it will revert to the lowest levels nor am I saying that I am buying at the best price. However it is a price I am comfortable with where I think it offers significant downside protection against further declines in the FTSE100 index

You may notice that I have not included anything on fundamental valuations in the market above. For stock specific investments this is something that I would almost certainly do. However given that all you are left with is market risk when buying an index (and country risk in this case) you're essentially looking to see if you think the market is overblown. The UK market has shown marked declines since the GFC and being part of Europe is being tainted with Europe's woes so I'm comfortable that even if it is expensive on current earnings, once confidence returns to the area then share prices / the price of my index will recover.

Again I want to stress that in investing in index's my thesis is not around absolute valuations in the way my stock investments are. They are about a diversified "safe" investment for which I'm trying to get some downside protection which is what the currency offers me.

The Chart on the left shows the FTSE100 return over the last ~10 years in GBP (blue line) and AUD (pink line). The gap is purely exchange rate differences. The exchange rate risk is that that the gap widens (from a negative risk perspective) or that the gap wides (positive from a risk perspective).

While charts like this are highly dependent on your starting point, this particular chart tells the same story for almost all starting points (it is worth checking this prior to actually making your investment)

Execution

Once I decided that I wanted to make this particular investment I started to look around for an ETF that would give me the right exposure. I wanted full currency exposure so did not want any sort of currency hedge. The easiest way is to look for an ETF listed in your own country. This wasnt an option for me so I found the iShares FTSE100 index listed on the LSE (LSE:ISF). They are also listed on various other markets but I only wanted to the AUDGBP risk (i.e. I didnt want USD / EUR risk also mixed in).

I then used my Interactive Brokers account to buy my desired quantity. Since my investment the currency has moved against me slightly and the index has increased slightly so I am showing on a slight negative return. Ishares (run by BlackRock) has plenty of these type of investments which are definitely worth checking out.

Investing in foreign index funds: the exchange rate opportunity

As I have mentioned in a previous posts, when your home currency is particularly strong (like the Australian dollar currently is) it makes a lot of sense to invest your money in overseas markets. The strong currency, especially if significantly overvalued, offers a great hedge against bad market performance.

For me personally, there is a double benefit. International markets (e.g. US, UK, Europe) have significantly underperformed the Australian stock market in recent years due to recessions in those markets (and the GFC) while there has been a mining / China related boom in Australia. That is not to say that these markets are cheaper on a multiples basis - the Australian market is actually cheap on a relative basis due to the high earnings levels. However currently risk in the Australian market is on the downside while many international markets offer significant upside risk.

What I mean by that statement is that although companies in Australia look cheap no their current earnings, the resources earnings are dependent on China. If China slows, these earnings slow which impacts the sentiment in the whole market and affects stocks totally unrelated to the mining sector. On the other hand given the low growth in the US / UK due to continuing threats of recession, the companies in these markets look relatively expensive based on current earnings. However the risk (measured as volatility) is on the upside (except Europe which is a special case) so if you're not looking for short term returns, the recovery in these markets could offer a very attractive return.

If my home currency was at fair value against the USD or GBP it probably wouldnt be worth the risk for me. I don't have time to keep track of these markets as well as my home market. However given how overvalued the currency is it provides a buffer against a downturn. Further by investing through an index ETF you're getting the total market return which means that you can just concentrate your efforts on the currency performance as there is no stock specific information that you have to keep a really close eye on.

The easiest way to invest in foreign index ETF's is to see whether there is one listed on your home market. iShares offers a wide variety of low cost ETF options. In Australia they have an S&P500 ETF (ASX:IVV), a Nikkei ETF (ASX:IJP) and various others. The key thing to look for is to make sure that there is no currency hedging. This totally removes the benefit of your strong local currency. If there is no ETF in your home market (e.g. there is no FTSE index listed in Australia) you may need to invest in an ETF on a foreign exchange. If you have a cheap international broker like Interactive Brokers this should not be an issue.

In my next post I will give an example of how I went about investing in a foreign ETF.