Some people shy away from investing in foreign markets because they fear getting caught out by currency movements. Swings in currencies can significantly affect portfolio returns and they are very difficult to predict, with the full implications even harder to track.
For equity investors it can be difficult to trace the impact of a currency movement as there are multiple moving parts. If you invest in a US company and the dollar rises, initially you will do well because the dollar has strengthened against the pound. But if the dollar has gone up and the company has a lot of customers outside of the US, they might end up selling less as their products look more expensive to overseas buyers. On the other hand, goods and services from overseas will be cheaper for the company to source.
“It’s so difficult to net off all the conflicting movements and work out what is the net impact of a currency move,” says Rachel Winter, associate investment director at Killik & Co. “In reality it’s not something I think is really possible for a retail investor so we just try to make sure we are as diverse as possible and hold a lot of different currencies”.
Exposure to foreign exchange movements is unavoidable if you want a diversified portfolio and access to some of the world’s best companies. The UK now accounts for under 5 per cent of global listed equity markets and just 2.25 per cent of global gross domestic product.
Even if you invest in a UK-listed company you will take on currency risk if the company conducts large amounts of business in foreign markets. This is likely to be the case if you are investing in a FTSE 100 company, as FactSet data shows that only 23 per cent of the market's revenue is generated in the UK.
Ms Winter advises investors to make sure they have a good mix of currencies in their portfolio so they can cancel each other out. She says you can then "forget about the currency aspect and focus on good companies”.
That said, some wealth managers do consider currency movements to be an important part of their asset allocation. While you may choose not to hedge currencies for a number of reasons, it is good to understand how they can impact your portfolio and might even prove useful in more tactical portfolios.
Richard Champion, deputy chief investment officer at Canaccord Genuity, says foreign exchange movements can make such a significant impact on returns that the team's investment philosophy describes currencies as "an additional source of alpha", with some investment decisions made accordingly.
The current state of foreign exchange
The pound has languished at low levels versus the dollar since the Brexit referendum in 2016. But in recent months we have seen the dollar come off quite sharply, largely because the Federal Reserve reduced interest rates, lessening the yield available on dollar assets and their attraction to investors. The US also faces political risk with its upcoming election, which may be weighing on the value of its currency.
While the dollar has weakened, Mr Champion believes it is likely to have come off as much as it is going to and his portfolios are currently overweight the currency compared with their standard allocations. He believes that the effect of interest rates weakening the currency is likely to have already played out and, if there is a second wave of coronavirus, the dollar is a traditional safe haven asset that could prove fairly resilient.
But there is great uncertainty about where the dollar is going next. Christoph Schon, executive director of applied research at Qontigo, a subsidiary of Deutsche Boerse, says much of the dollar price depends on the role assigned to it going forward. For much of the past four years, during the so-called “Trump rally”, its value has been positively correlated with stock markets. But since the sell-off in March they have been inversely correlated, with the currency weakening as share prices return to record highs.
Mr Schon says: “The negative correlation between the dollar and stock markets seems to persist, which means that UK investors looking to benefit from a continued rise of share prices in the US could see up to one quarter of their gains erased by a weakening of the dollar against the pound.”
Ed Smith, head of asset allocation research at Rathbones, says that in the short term currencies are “as good as unpredictable”. In the long term, he thinks the dollar does look overvalued against most currencies, and has done for some time, both on simple frameworks such as purchasing power parity and more complex ones such as his favoured behavioural equilibrium exchange rate, which links exchange rates to economic fundamentals. But he adds: “The extent to which the dollar will continue to converge back towards its long-run “fair value” depends at least in part on the extent to which the global economic recovery continues.”
Closer to home, the pound is a relatively cyclical currency, which means that when investor sentiment is riding high – if the global recovery is stronger than expected, for example – it tends to appreciate against the dollar and the euro. When people feel gloomier, the pound tends to fall.
Brexit is also still a risk for the pound this year, and if no trade deal is reached by January sterling is likely to see more volatility. But looking through the short-term noise, Mr Smith suggests that the pound "may not be too far from its long-term floor", giving it more scope to rise than fall.
Manage currency risk in your portfolio
Firstly, review your portfolio as a whole and check you are happy with the amount of currency exposure you have around the world. If you have a broadly diversified international portfolio (of mainly equities) you will have a broad mix of currencies, which can cancel each other out and reduce net foreign exchange risk.
"For most investors, currency hedging is an unnecessary expense; you are more likely to benefit from diversifying your portfolio than trying to predict currency movements," says Henry Botting, assistant investment manager at OLIM Investment Managers. He adds that leaving a portfolio unhedged can actually lower overall risk by providing a low-cost hedge against unexpected inflation in the investor’s own country and currency.
Edward Park, deputy chief investment officer at wealth manager Brooks Macdonald, says the team's philosophy in general is to hold equities on an unhedged currency basis and fixed income on a hedged basis, because currency volatility can be significantly higher than the price volatility of a shorter-dated bond.
He says: “If we hold a constructive view on an equity market it is possible that the increased sentiment towards that region will either be played out in currency or stock market appreciation,” so unhedged exposure can give you access to both currency and stock price appreciation. Mr Park adds: “Based on our current market views we do not have sufficient conviction on any of the currency majors to move away from our default investment philosophy of keeping equities unhedged and fixed interest hedged.”
Ben Yearsley, director at Shore Financial Planning, however, says that there are times when sterling looks mispriced by a wide enough margin to consider doing something about it. He switched a Japan fund and an infrastructure fund into their hedged versions at the beginning of this year because he took the view that, on a three to five year view, sterling looked quite cheap. Hedging share classes tends to work best with single country (or currency area) funds such as the US, Europe or Japan.
The chart above shows how an S&P 500 tracker hedged into sterling has underperformed its dollar counterpart over the past five years. If you believe it is time for sterling to make gains, and decide you want to hedge currency exposure, make sure you are happy with the additional cost.
If you are investing in funds or ETFs, the easiest way to hedge is via a hedged share class, which is likely to be more expensive than its base currency counterpart. For example, iShares Core S&P 500 UCITS ETF (CSPX) has an ongoing charges figure of 0.07 per cent, while the cost for its sterling-hedged share class is 0.1 per cent.
Many mutual funds also offer hedged share classes, while investment trusts that hold overseas stocks do not. But some managers have a currency hedging policy where they may use derivatives to hedge against foreign currencies. For those holding overseas shares directly, exchange rates could affect the attraction of taking profits.
You can also buy derivatives to hedge currencies, but make sure you fully understand how the derivative works if you go down this route. You could use a forward exchange contract, for example, where you lock in an exchange rate in the present for a predetermined date in the future. Or you could opt for a contract for difference (CFD), where you agree to exchange the difference in the price of two currencies from when the position is opened, to when it is closed. With a CFD you do not have to own the underlying currency, so only a small amount of capital is required to enter the hedge. But it could leave you with large losses if currencies do not move in your favour.
Over full business cycles, perhaps every 10 years or so, you might be able to expect various currencies to cancel each other out to an extent. So for most long-term investors, the cost and risk of fiddling around with currency hedging is unlikely to be worth it. But for tactical investors it may provide you with a boost to your returns.
