Don't ignore currency risk when retiring abroad

ANDREW'S PORTFOLIO

Source: Investors Chronicle *Trustnet **Reuters and ***Bloomberg

I UDS=0.65 GBP, 1 CHF=0.69 GBP and 1 NOK= 0.11 GBP

Price and value as at 25 July 2013.

LAST THREE TRADES

Real Estate Credit Investments (Buy), Baillie Gifford Shin Nippon (Buy), Sands China (Buy)

WATCHLIST

Biotech Growth Trust, Greenwich Loan Income Fund, Middlefield Canadian Income.

Chris Dillow, the Investors Chronicle's economist, says:

Most investors can ignore currency risk. Not you. You have a mismatch between your assets and your liabilities, which exposes you to just this risk. Because you intend to retire to Malta, most of your future expenses will be in euros. But most of your portfolio is in sterling- or dollar-denominated assets. This poses the danger that if the euro rises your future costs of living will rise without any compensatory rise in your assets.

We can, roughly, quantify this. Since 2000, the volatility of annual changes in the euro-sterling exchange rate has been seven percentage points. This implies that there is a one-in-six chance of the euro rising 22 per cent over the next five years - and, therefore, of your costs of living rising substantially.

In fact, the risk is worse than this. Historically, rises in the euro have more often than not been accompanied by falls in share prices: since 1990, the correlation between annual changes in the All-Share index and in the euro (or ecu)-sterling exchange rate has been 0.42. This raises the danger that your future cost of living will rise at the same time as your shareholdings fall.

Your portfolio does not much protect you from this risk. Although it has a few defensive holdings such as Standard Life's AAA Income Fund and the oil majors, these are offset by riskier emerging market and small-cap holdings.

So, what can we do to reduce this exchange rate risk? The obvious solution is to hold euro-denominated cash. But this has an equally obvious drawback - it has almost zero return.

How much this matters depends upon some idiosyncratic variables.

One is: how do you define "retiring comfortably"? Right now, this portfolio could give you an income of around £25,000; I'm basing this on the amount you could probably take from it each year without eating into current capital. The further below your target level of income this is, the more you need to stick with your higher-risk, higher-return strategy.

Another is: when will you retire? The more working years you have ahead of you, the safer it is to hold a portfolio such as this. This is because your labour income helps to diversify equity and currency risk. And if you can choose your time of retirement, you have the option of working longer if those risks do materialise.

Third, there is the matter of your attitude to risk. Risk cuts both ways. Although there's a risk of the euro rising and your shareholdings falling, there is the risk of the opposite - that you get the double victory of rising share prices and a weak euro (the central case scenario is for equities to rise while the euro stays more or less around current levels). The question is: how willing are you to tolerate the risk of a strong euro and falling share prices in exchange for the upside potential of this portfolio?

This question interacts with our first. People often take risks they would not otherwise accept if their wealth is short of their reference level. The more desperate you are to raise your retirement income, therefore, the more you're likely to tolerate risk. This is not necessarily irrational. What is irrational is pretending that the risks are small just because you want them to be.

Ultimately, the choice is yours. One possible compromise here would be to shift some of your wealth into a euro-denominated equity tracker fund. This would have the virtue of retaining equity exposure while reducing currency risk - although this would come at the price of slightly lower expected returns in good times, to the extent that rises in global equities are more often than not accompanied by falls in the euro.

Christopher Wicks, chartered financial planner at Bridgewater Financial Services, says:

This portfolio consists of a combination of direct equities and equity funds with some property exposure, which puts you in the highest-risk category. Your direct equities provide concentrated exposure to the fortunes or otherwise of a limited number of companies and therefore provide an added dimension of risk. The portfolio also contains funds that provide concentrated exposure to specific regional markets such as Brazil, Eastern Europe and China, and is essentially constructed for speculation rather than disciplined investment to achieve specified goals.

Without knowing what risk exposure you are trying to achieve or anything about your other assets or goals, it is impossible to really contextualise this portfolio. If it is a standalone portfolio without any lower-risk or material cash assets, then it incurs an excessive level of risk. You could be lucky and do very well or it could all go badly wrong.

It also depends on how long you plan to invest for. With the exception of your iShares funds, the majority of your funds are actively managed. This means the fund managers will be engaging in stock selection and market timing, neither of which strategy has been shown to make a particularly useful contribution to portfolio returns. Active fund managers, bar a very small minority, fail to consistently outperform markets.

What does make an enormous contribution to returns is high-level asset allocation. This is the split between equities and bonds, and controls the risk and expected returns on the portfolio. We also follow the fairly consistent evidence across most major world markets that investments in undervalued and smaller companies can provide an added dimension of risk and therefore potential return in excess of the market.

When it comes to fund selection, we prefer to use low-cost institutional funds which provide the levels of exposure to the markets we seek. Our portfolios get out of kilter over time due to market movements so we rebalance them as and when needed to restore the correct risk/return profile.

A portfolio should be diversified as this enables returns to be improved without taking extra risk overall, and there is a diversification benefit in holding property. However, for private investors, funds that hold bricks and mortar can cause problems with liquidity, and funds that invest in property shares can be highly risky due to the considerable levels of borrowings they contain. On balance, we have concluded that for retail investors property investment causes more problems than it solves and we tend not to include it in our portfolios.

It is clear that you enjoy picking funds and some of them may have done very well. That said, if you are relying on the portfolio to generate a retirement fund to support you in due course, given your age, in the next seven to eight years you should seriously consider the adoption of a more structured and disciplined approach which reflects the risks that are involved and the impact of these on your plans. If you wish to continue to speculate, you should be clear that this is fine for fun, but it should not be confused with serious investment. So perhaps you should earmark a proportion of your retirement fund for this.

As for the remainder, by adopting a top-down approach based on the correct asset allocation for your required level of risk and duration of investment, you are more likely to achieve the results that you seek.

You also say you want to retire in Malta. I don't know where you live now but you need to take into account your current and future tax position, and ensure that your investments are held in an appropriately tax-sheltered manner, as far as possible.