Invest around currency risk

The pound’s gyrations have had several effects on UK investors. The initial devaluation ushered in a period of increased inflation, and investors’ capital has needed to work harder to beat this. As the two-year deadline of the Article 50 notification draws nearer, there could be further currency volatility to come.

Pound problems

“There is the risk of further sterling weakness if we don’t get a Brexit deal,” says Adrian Lowcock, head of personal investing at Willis Owen. “If we do get a positive deal, which might only come through at the 11th hour; the pound would get weaker and then move up quite sharply.”

Investors worried about a no-deal Brexit may be tempted to reduce exposure to the UK because of the negative impact EU negotiations have had on sterling. But, rather counterintuitively, this may not be a good idea. 

“There may be some disruption in the shorter term and further weakening of sterling after the deadline for Article 50 expires in March,” says Kay Ingram, chartered financial planner at LEBC. “But these days investing in the UK doesn’t mean that you’re investing in the UK economy. Some FTSE 100 listed companies have nothing in the UK apart from their headquarters."

FTSE 100 companies on average receive around 70 per cent of their underlying earnings from countries outside the UK. And FTSE 250 companies receive around 50 per cent of their earnings from abroad. If sterling weakens further, companies with high exposure to overseas earnings would get a boost when earnings are translated back into pounds. So much of the stock market has in-built international diversification. 

Ms Ingram adds: “UK equities are also looking cheaper at the moment, so if you’re a sterling investor you can achieve the best of both worlds by moving into a UK fund that is listed in sterling but invests in globally orientated companies.” 

Working around currency risk

Large-cap and internationally focused UK companies provide some protection against sterling woes. Despite this, investors must consider currency risk. This is the movement of the currency your investment is denominated in against your home currency and it can both help and hinder your returns.

Too much reliance on UK stocks to heal sterling woes could create problems if the pound starts to rise. “If we get a soft Brexit, funds with lots of overseas exposure will suffer in the short term,” warns Ryan Hughes, head of active portfolios at AJ Bell. “Investors need to remember that doesn’t mean the manager is bad. They might have done a very good job but the currency effect has cancelled it out. So investors need to look closely at their portfolios and understand the drivers.”

But Chris Dillow, Investors Chronicle’s economist, thinks it’s not a good idea to try to second-guess where currencies will go, even though it is important to understand currency risk. Over the long term, currency fluctuations can even themselves out. He says: “We have lots of evidence that exchange rates are very likely unpredictable, certainly over the short term, which means we should ignore them in most cases.”

For this reason he does not recommend that UK investors buy in currency-hedged funds. These aim to neutralise the impact of any currency fluctuations so you only get the investment returns. But not all funds offer them and these share classes can be more expensive than share classes that don’t hedge the underlying currency. Also, exposure to a foreign currency sometimes provides excellent returns and diversification from unpredictable situations – such as the Brexit vote.

“If the exchange rate is just random, then what’s the problem?” says Mr Dillow. “Even if there was a major shock to the economy and the pound fell further, UK investors, in effect, have already got a hedge, as the FTSE 100 is an index of multinationals. So, I wouldn’t bother with general hedging, as you’d be paying for insurance that you don’t really need.”

“Hedging currency is a hugely complex area and one that is fraught with danger as if you get it wrong you may miss out on substantial returns,” adds Mr Hughes. “If you are choosing to hedge right now, you would need to be fairly certain of how the Brexit negotiations are going to go [as the outcome will be binary] and I certainly haven’t met anyone who can predict that.”

The right level of international diversification

So it is better to work out what level of international diversification suits your needs rather than trying to predict how currency movements might affect your investment returns. This will be different depending on your investment goals, the amount of time you intend to invest for, and your personal circumstances.

If you currently live in the UK and plan on doing so for the foreseeable future, generally analysts suggest most of your assets should be in sterling as this is the currency your expenditure will be in. For example, AJ Bell's ready-made portfolios for balanced risk investors have roughly 45 per cent in overseas assets and 55 per cent in UK assets.

“Over time, having a little more of your assets in your home market and a little less in overseas markets should dampen out your volatility,” explains Mr Hughes. “But that point is predicated on the assumption that sterling is considered a relatively strong currency compared with others. If, for example, you were a Turkey-based investor you wouldn’t want to have lots of assets in your own currency, due to its weakness.”

If you are drawing a retirement income, it’s a good idea to have more in the UK as you do not want any variations in currency to have a knock-on effect on how much income you receive. And the UK is well-recognised as a high-paying income market. Ms Ingram also suggests income investors have roughly 55 per cent in the UK and 45 per cent overseas.

However, growth investors who can take on more investment risk could increase exposure to overseas assets. This could include people looking to build their wealth, such as younger investors who can invest for several decades. Generally, younger investors can take on higher investment risk than older investors as they have longer to ride out any falls in the market.

The UK’s current economic situation might make it even more important for them to hold overseas assets.

Mr Dillow says: “There is the possibility that the UK could suffer long-term economic decline which would see a young investors' return on their human capital fall, in addition to a potential fall in sterling and UK equities. Therefore, some people think there is a case for them to own more overseas equities and currencies.”

For investors who can take on higher risk, Mr Lowcock suggests a portfolio with around 30 per cent in the UK and 70 per cent in overseas assets. AJ Bell has a similar weighting in its higher risk portfolios. For these investors, high-growth areas like Asia and emerging markets are particularly attractive, Mr Hughes says, as long as you can invest for at least five, preferably 10 years, to ride out both the currency and stock market volatility.

Another reason why you might want to have more in overseas assets than sterling assets is if you have current or future liabilities abroad. For example, if you are planning to retire overseas it is a good idea to keep a cash reserve in the local currency.

“If, for example, you’re planning on buying a home in Spain, that would make you vulnerable to sterling falling against the euro and your pounds buying you less,” explains Mr Dillow. "The purist hedge is to back the euro itself.”

In this example, if sterling were to strengthen against the euro, your pounds would go further when purchasing a property, working out well for you either way. The downside of keeping a cash reserve in euros is that cash saving rates are low. “But you are buying insurance and insurance is expensive,” says Mr Dillow .

If you have overseas assets, such as international shares, that you want to sell, try to think of the currency consideration as separate from the investment decision. This is because the best period to exit a market is not always the same time as a favourable currency exchange. Ms Kay says she’s had clients who were reluctant to sell international assets because the currency relationship with the pound meant their returns would be worth less when translated back into sterling.

“If you’ve got a property in France, for example, and you want to get rid of it don’t hold off selling it because sterling is weak,” she says. “It’s better to sell the house and park the money in a euro-denominated account. And if you have a second home or work abroad it’s always worth keeping a cash account in the local currency so you’ve got some spending money and are not having to rack up costs changing money all the time.”