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How to manage currency risk

International investing offers many benefits but currency movements can erode your gains. Daniel Liberto explains how to minimise the risk
How to manage currency risk

The case for investing overseas has perhaps never been stronger. Political turmoil, stagnant economic growth, the mounting prospect of a messy divorce from the European Union and years of potential trade upheaval have cast a dark cloud over UK companies, increasing the urge to tie up capital in other regions of the world.

International investing offers many benefits. It reduces the risk of being overexposed to one geography and business cycle, as well as providing access to a much wider selection of compelling companies, industries and opportunities, some of which aren’t available on these shores. It’s simple to do, too – a rugged, welldiversified portfolio of international shares can now be built with just a few clicks of a button.

Still, there is one major caveat: most foreign equities are priced in their home currency. When you buy shares in a company listed in your country, the value of your investment is determined by changes in the stock price. That isn’t the case in international markets.

Let’s use Amazon (US:AMZN), one of the most popular overseas investments in recent years, as an example. The online retailer’s shares rose 28 per cent in 2018 and 56 per cent in 2017. Adjusting for currency, in this case pound sterling, those returns translated into 36 per cent and 42 per cent, respectively, excluding fees.

For most investors, buying shares in an overseas company means betting not just on its performance but also on its currency. Holding non-sterling assets opens you up to foreign exchange (FX) risk. This will work in your favour if the value of the currency of the company you invested in rises against the pound – and eat into your returns if the opposite scenario plays out.

Here are some simple strategies to help manage those risks and prevent any nasty surprises:

 

Understand what drives currency prices

To successfully invest overseas, first you need to grasp what makes currencies tick. Understanding the basics could save you a lot of hassle and money in the long run.

Like anything, the value of currencies is determined by supply and demand. Key indicators that can help determine where a currency is heading versus the one it is competing against – they trade in pairs – include the following:

  • Trade balances: Current accounts measure economic transactions between a nation and its trading partners. They break down how much a country spends on imports and receives for exports, effectively telling us which currency is in higher demand, at least for the time being.
  • Inflation: When appetite increases prices rise, making a country’s products and services more expensive for foreign people to buy. This weighs on demand for goods and the currency used to purchase them.
  • Interest rates: Central banks raise interest rates to keep a lid on inflation. Higher returns are offered to encourage people to save more, rather than spend, attracting an influx of foreign capital and lifting the value of the currency.
  • Public debt: Overseas investors tend to avoid ploughing capital into countries financing lots of new projects with mountains of debt. They know this will eventually trigger high inflation and that the debt will probably have to be serviced by lowering interest rates.
  • Strength and stability: Economical strength and political stability, on the other hand, are good omens. Countries in fine shape and unlikely to face any nasty surprises attract capital from all over the world, pushing demand for their currencies up.

 

Buy strong, sell weak

Last year, as the Amazon example shows, UK investor returns in the US were boosted by the dollar appreciating against sterling. The general rule of thumb is to buy foreign equities when the pound is strong, relative to the other currency, and sell when it’s falling.

When your local currency is strengthening against the currency of the company you want to invest in, your purchasing power increases, and your money goes further. For selling, it’s the other way around: a weakening currency back home boosts the value of your stake because it’s held in a currency worth more.

By now you should be aware of the basic factors that drive currency valuations. Political instability forces them lower and makes them volatile, as has been the case with the pound since the Brexit referendum in 2016.

At this stage, predicting where the pound will go next is anyone’s guess. After Theresa May’s efforts to get her Brexit deal over the line failed, the currency has been in free fall again.

The market appears to be pricing in the increasing likelihood of the UK leaving the EU in October 2019 without a trade agreement, a prospect that many pundits predict could tilt the economy into recession. Fears that another general election could be called is also weighing on demand for the currency.

At this stage, the slightest glimmer of good news, namely anything to defy those gloomy forecasts, will almost certainly lead the pound to rebound. That said, in today’s politically uncertain environment, sentiment could just as easily spiral further downward.

Predicting currency movements has now become even harder. At present, there may be a case for cashing in on your foreign earnings but using pounds to buy into another currency is probably best avoided.

 

Minimise foreign exchange charges

Fees are another thing to think carefully about. Returns on international shares can quickly be whittled down by unforeseen dealing and foreign exchange (FX) charges.

To master the art of minimising currency risk it’s essential to invest through a platform that doesn’t charge an arm and a leg to convert them. Every time you buy an overseas holding, your pounds will be exchanged into the currency of the company you invest in. Then, when you sell the process will be repeated, converting whatever returns you generated back into pounds.

Check out what extra spread each platform adds to the interbank exchange rate. You’ll be surprised just how many of them get away with squeezing money out of investors this way.

Fees generally tend to range from 1 per cent to 1.5 per cent per transaction. That might not sound like much but they can soon add up over time – and may make you think twice about regularly tweaking your portfolio.

Also, beware of charges converting dividend payments. These can sting. The UK has historically been very rewarding to investors hunting income, yet it never hurts to look further afield, particularly if you’re worried that some of these dividends will be axed because of domestic issues.

Abroad, there are plenty of reliable deliverers of steady, solid income and capital appreciation. To make the most of them, try to find a platform that charges less to convert dividends into pounds.

A little homework comparing the various FX fees of platforms could save you a fortune in the long run. Alternatively, you could explore the following potential solution.

 

Open a foreign currency account

When you invest abroad using pounds sterling, you are constantly at the mercy of exchange rate fluctuations between your local currency and the one in which the shares are priced. This impacts your ability to invest as you normally would do. For example, you might feel forced to hold on to a stock you’re desperate to get rid of because an unfavourable exchange rate threatens to drastically widen your losses or cut into your gains.

Fortunately, there is a way out of this – and the irritating reality of being repeatedly hit with currency exchange fees. A handful of investment shops, including Interactive Investor, HSBC and Charles Schwab UK, enable customers to hold foreign currency in their share dealing accounts.

Trading in the same currency as the equities they buy gives investors greater control over FX risk. Once the money is converted and funded to the account, you can invest like a local without worrying about exchange rates. The only time you need to fret is when you transfer capital in or want to turn it back into pounds again.

The way sterling is currently trading, it’s understandable that regular overseas investors would prefer to hold onto other currencies with stronger pricing power. When it ticks the right boxes the US dollar is often the most popular option. The North American stock market is huge and also happens to house several foreign companies from Asia and Europe.

It’s worth bearing in mind, though, that foreign currency can only be deposited in a regular dealing account or self-invested personal pension (Sipp). HM Revenue & Customs’ rules forbid anything other than sterling being held in a tax-protected individual savings accounts (Isa).

Regular trading and currency conversion fees apply, too. When possible, it’s best to fund accounts using a competitively priced money exchange transfer service such as TransferWise. Brokers tend to charge more for this service.

 

Use funds to hedge currency losses

International investors have several other options to neutralise movements in exchange rates. Popular choices include currency-hedged mutual funds, exchange traded funds (ETFS) and derivatives such as futures and options, which are essentially contracts giving investors the obligation or right to buy or sell a particular asset, in this case currencies, at a later date for an agreed price.

ETFs are perhaps the most advisable. They offer the opportunity to invest in a vast array of currency pairs and are generally more accessible, straightforward and cheaper than traditional derivative products.

In their simplest form, these passive vehicles hold cash deposits to replicate the movements of a currency. If you plan to invest, say in Australia, but are worried that the local currency will fall against sterling, you could invest in an ETF that enables you to long the pound versus the Australian dollar, or the other way around.

To successfully execute this strategy, it’s important to pick an ETF that matches your individual needs. Occasionally, they use future contracts to track exchange rates. Others measure one currency against a basket of different ones, leverage exposure or may rebalance just once a month.

You should also bear in mind that an effective hedging strategy requires constant tweaking. If the value of your foreign holding goes up, so too should your currency hedge. Failure to act could leave some capital under-protected from exchange rate fluctuations.

Some investors might find this daunting and prefer to outsource international stock selection and FX risk to a third-party. To meet these needs, some UK-based global actively managed funds offer currency-hedged share classes.

Equipped with a variety of tools, their goal is to strip out any currency fluctuations from a portfolio of overseas stocks. They don’t always succeed, though, and lately have lost investors a fortune.

The recent travails of currency-hedged funds offer an important lesson: exchange rate hedging should only be employed when the currency of the stock you're investing in is likely to decline. When sterling is out of favour, as it is now, you’re better off avoiding this strategy – and the extra costs associated with it – unless you’re confident of a rebound.

 

Sit back and do nothing

Funny enough, there’s also a case to be made for letting nature take its course. Beyond finding ways to keep fees down as much as possible, sometimes it’s best to do nothing, regardless of whether currencies move against you or not.

Over the short term, exchange rate fluctuations can inflict some real damage on portfolio returns. However, if you’re investing for the long term and aren’t the trigger-happy type, you’ll probably find that these movements eventually cancel each other out.

The average economic cycle lasts about a decade. During this time, currencies generally go from boom to bust as well, appreciating as the economy gets stronger until they top out.

It’s also worth remembering that we mainly invest in international companies for two reasons: to chase higher returns and shelter portfolios from being overly dependent on the health of one nation. Having exposure to different currencies reduces correlation between assets, helping to make portfolios more diversified.