Manage the impact of exchange-rate risk with your asset allocation

"This portfolio is the budget for these endeavours and it's denominated in sterling," explains Richard. "It is spread across three pension accounts that I am in the process of consolidating.

"I started making major contributions to pensions in 2007 and, until very recently, they had mostly been invested in global equity exchange traded funds (ETFs). The self-invested personal pension (Sipp) has grown far ahead of the 4 per cent real growth rate that I was hoping for in sterling terms. But looking at what it will buy in euros, the picture is not nearly as positive.

"I want to take a lump sum of €150,000 (£133,426) from this portfolio, and then €25,000 a year from around 2025. Over the long term I am not optimistic about UK economic prospects relative to the European Union (EU). However, I don't believe that when the Brexit dust has settled, the prevailing rate of exchange will be around €1.10 to the pound, so I don't want to move my assets into euros in one go now.

"I think that in two years I will be able to buy more euro-denominated equities and bonds than I can now with sterling assets. But if I am wrong I will bite the bullet and make the final switch, resigning myself to European life on a lower budget.

"But what would you suggest?"

Richard's portfolio

NONE OF THE COMMENTARY BELOW SHOULD BE REGARDED AS ADVICE. IT IS GENERAL INFORMATION BASED ON A SNAPSHOT OF THIS READER'S CIRCUMSTANCES.

THE BIG PICTURE

Chris Dillow, Investors Chronicle's economist, says:

For most investors, this would be a good portfolio, being heavily weighted towards equity trackers, which have lower costs than many active funds. You, however, have a problem: there's a mismatch between your assets, which are mostly in sterling, and your future outgoings, a lot of which will be in euros.

You, therefore, face two risks. One is that sterling will fall against the euro, in effect raising your future cost of living. The other is that equities generally will fall, meaning your ability to buy goods and services in any currency, including euros, will be reduced.

These two risks are related. If investors dump shares because they become more risk-averse, they might also dump riskier currencies. In such an event, the euro would rise against the pound as shares fall, so you'll lose on both fronts. This is what happened in late 2008, for example.

In this context, however, economic theory offers some comfort. It says that the least bad forecast of a future exchange rate is the current rate – many economists believe that exchange rates follow a random walk. As Kenneth Rogoff, professor of public policy and economics at Harvard University, says: forecasting currencies is "a remarkably difficult task". This implies that you don't need to do anything.

But things might be even better than this. One view is that sterling has overshot on the downside because traders overreacted to the vote to leave the EU, causing the pound to become undervalued. As this undervaluation corrects sterling could rise meaning you could buy more euros, which also suggests you should do nothing.

However, I'm not sure that you should stake everything on these views. Investors must prepare not only for the most probable outcomes, but also for low probability and high-cost scenarios. For you, one of these is that sterling will fall. This argues for partially shifting into euros now to lock in the euro value of this portfolio. So the question is, what mistake would you rather make?

If you shift into euros now, you risk missing out on future gains, as sterling, share prices or both rise in euro terms. This is because a sterling-based portfolio can rise in euro terms if either sterling rises against the euro or if the shares it holds rise in euro terms – or both.

But If you don't shift into euros now you risk losing out if the euro rises relative to this sterling-denominated portfolio. So it's impossible to make the perfect decision here.

But what you can do is reduce future regret. You can, of course, fudge this by making a gradual switch into euros – buying some now, some next year and so on. Asset allocation isn't all or nothing.

But there is another danger here – that in focusing on exchange rate risk you forget that equities could fall. This might well be a bigger risk than the possibility of sterling falling: equity volatility is generally higher than exchange rate volatility. So are your cash holdings large enough to protect you from this risk?

Daniel Bland, investment manager at EQ Investors, says:

Asset allocation is key to portfolio management. In your circumstances you should aim to ensure that asset allocation decisions manage the impact of exchange rate risk, a difficult task for UK private investors.

Your portfolio has an equity weighting of over 80 per cent and cash of over 13 per cent if you include the cash that some of the funds may hold, with the remainder spread across commercial property and bonds.

Most non-equity fund investments will be hedged to sterling. For example, a fund manager may own a bond that pays in euros but will use derivatives to swap the euro return for the sterling return. And, generally, most alternatives provide a sterling return. So your non-equity investments, around 18 per cent of your assets, which are presumably diversifiers seeking low volatility of return, are effectively carrying increasingly volatile euro/sterling exchange rate risk.

The bulk of your portfolio – equity funds – will not normally hedge returns to sterling. Therefore, this portion of the portfolio is multi-currency.

Currency attributions based on a company's jurisdiction help form an overview. You have a heavy skew to the UK, which is quite normal for sterling-based investors. But companies increasingly have global reach and their revenue spans multiple currencies, the reporting of which is often not entirely clear. For example, companies in the FTSE 250 index, in which you have over a quarter of your assets, derive 40 per cent of their underlying revenues from the UK and about 15 per cent from the eurozone.

I also suggest working with a financial planner to carry out cash flow analysis to help manage sequencing risk as you draw on your pension. Also consider whether your Sipp is the most effective portion of your wealth to draw on.

With some adjustment you stand a reasonable chance of achieving your desired plan.

Rory McPherson, head of investment strategy at Psigma Investment Management, says: 

Your objectives are not unrealistic, but require thought. Given where valuations are and how long we have been in this expansionary cycle, it is reasonable to assume that future returns will be lower than those you've enjoyed over the past 10 years. If I assume a 4 per cent growth rate, net of all costs, for your portfolio, then you should have a pot of around £780,000 in seven years' time – the point at which you say you are looking to reduce your workload.

This will reduce to £650,000 if you take your pension commencement lump sum. Any drawdowns you take from your Sipp over this sum will be subject to your marginal rate of tax, which needs to be taken into account when planning how you will provide your desired €25,000 a year.

Your target income level is roughly 3.5 per cent, which assuming you have no other income, would equate to a gross yield of around 4.5 per cent. This is pretty high and would almost certainly deplete the capital of your portfolio, so you should consider if you can manage with a lower level of income.

Currencies are very hard to call, and on valuation measures both sterling and the euro look cheap. It may be worth using a fund with a euro-hedged share class for your core global equity exposure, which would move roughly 25 per cent of your currency exposure into euros.

And I would suggest gradually moving at least 50 per cent of your currency exposure into euros. You could also do this by buying European stocks, which are decent value, and denominated in euros. This would still provide an opportunity to make money should sterling strengthen, but would also minimise regret should it remain in limbo.

HOW TO IMPROVE THE PORTFOLIO

Daniel Bland says:

To meet your ultimate objective it would be prudent to adjust your equity asset allocation towards European companies. Oyster Continental European Selection (LU0995827317) is an actively managed fund investing across the market-cap spectrum, alongside which it would be prudent to hold a European large-cap tracker.

A tilt toward euros would also be sensible. Look to euro money market funds for cash, euro bond funds which aren't hedged to sterling and European commercial property. Options include TR Property Investment Trust (TRY), which has a pan-European property focus. However, this is trading at a slight discount to net asset value in contrast to the wider discounts it has been at over the past couple of years, so watch out for a more attractive entry point.

For alternative assets, Greencoat Renewables (GRP) offers an interesting mix of euro returns and inflation-linking. It is an Irish investment company with a London listing and invests in wind farms, which benefit from the generous subsidies available in Ireland. The trust plans to expand by making acquisitions in continental Europe.

Take a dispassionate approach to this re-structuring, setting your target positions and building them gradually over two years. During this period, consider reducing the overall risk with a lower equity allocation. Correctly allocated euro-denominated non-equity investments will reduce both overall investment and currency risk.

Rory McPherson says: 

Your portfolio is generally in good shape. However, there are two key issues to consider: have you got the most appropriate mix of assets and what should you do with regard to currency?

The lion's share of your portfolio is in equities, which have done fantastically well over the past eight years, but given your income needs in six to seven years' time it might make sense to de-risk your investments. I would need much more information to ascertain your risk tolerance, but having an allocation of around 20 per cent in fixed-income assets would seem sensible from what you have said here. Options include MI TwentyFour Dynamic Bond Fund (GB00B5VRV677), which yields over 4.5 per cent and has very little exposure to rising interest rates – the key concern for bond investors.

Over half of your portfolio is in UK assets. While this might seem a high proportion, much of this exposure is to large global companies that derive a substantial portion of their earnings from overseas. You should have been a big beneficiary of sterling weakness due to the overseas currency exposure within your UK holdings, and your global holdings which don't have any currency hedging. 

However, your large holding in HSBC FTSE 250 Index (GB0000467810) is subject to Brexit risk and this is an area of the UK market that has done fantastically well over the past 10 years. So it might be wise to trim this and reduce UK-specific risk. 

In addition to owning more bonds and fewer UK assets, you could increase diversification by adding assets that build in more protection and yield. Jupiter Absolute Return (GB00B6Q84T67) run by James Clunie should do well if the market comes off a bit, as might a small allocation to gold stocks via a fund such as BlackRock Gold and General (GB00B99BDY18). MI TwentyFour Dynamic Bond would help push up the portfolio's natural yield, as would Legg Mason IF RARE Global Infrastructure Income (GB00BZ01WV25), which targets a yield of 5 per cent.