You can ignore currencies if you live and work in the UK and primarily invest in UK-based companies focussed on the domestic economy. But to do so you would seriously restrict your investment potential and concentrate risk.
Exposure to global markets gives access to a world of opportunities outside the UK that not only have higher growth possibilities but also offer real diversification. This is a free lunch you cannot miss!
Yet it is amazing how many portfolios still suffer from “Home bias”, as it is known. Until recently, in fact, it was received wisdom to have an outsized UK allocation.
How currency exposure can kill (or enhance) returns
But venturing overseas carries risks. Currencies can have a big impact on investor returns. Consider this basic scenario:
Jim buys 100 shares of Apple stock at a price of $100. Cost = $10,000. Exchange rate is $1.25 to £1.00, so the shares cost £8,000.
Six months later, Apple shares have risen to $115. Jim sells the shares realising $11,500 for a gain of 15%.
Jim converts the proceeds back to Sterling, which has strengthened to a rate of $1.35 to £1.00. The proceeds, in pounds, are £8,500 for a gain of £500, which is 6%.
The same investment into the same company wiped out 9% of Jim’s gain once currency movements were taken into account. He made the right call on the stock but forces completely outside of his control cost two-thirds of his return.
Forecasting currency movements is really hard
Of course, currencies rise and fall in value against each other all the time, so this could have gone the other way and boosted Jim’s return. But the evidence suggests that trying to predict these movements – which add up to a daily trading volume of $6.6 trillion, making currency markets by far the biggest in the world – is a fool’s game. They often confound expectations and even the most logical analysis.
We have just seen an example of this. The value of the pound fluctuated before, during and after the UK election but not always in quite the manner anticipated:
Buying the pound seemed like the obvious move once the election result became clear; many forecast Sterling would rebound to something like $1.40. Sure enough, the pound initially rose sharply after the election result became clear. But, as of 14th January, it is, in fact, lower than before election night.
Currency movements are driven by a dazzling array of factors that elude attempts to model and predict where they will go.
Hedging your bets
One way of gaining the benefits of exposure to global markets without the currency risk is to pay to remove the risk, also known as “hedging”. This can be done fairly easily by buying “hedged” share classes of overseas funds. At the cost of a higher annual management charge, you can buy the same fund and capture the underlying investment return without the impact of currency movements.
Usually the additional annual fee is not onerous (e.g., the iShares Core MSCI World UCITS ETF costs 0.20% per year; the same fund but in a share class hedged to Sterling costs 0.30%).
But remember, the hedging works both ways: you are protected from adverse movements in the value of the pound but equally will not benefit if those movements work in your favour.
So it worth paying to remove the effect of currency movements?
We don’t think so. UK investors should probably stay unhedged most of the time.
There are, in fact, sound reasons for UK investors to keep overseas holdings “unhedged”, in other words at the mercy of global currency market movements.
Firstly, left to their own devices, currency movements ebb and flow and tend to wash out over time. Sometimes they will help you, sometimes they will hinder you. The diversification benefits of exposure to a massively larger pool of investments worldwide outweigh the (often short-term) swings in currency values.
Secondly, UK investors are lucky. Sterling used to be the world’s primary currency until the middle of the 20th century when the dollar took over. As a result, when there is fear and panic in world markets, what tends to happen is that demand for US dollars (in blue) and to a lesser extent Swiss francs (in orange) and Japanese yen (in yellow) tends to rise.
Here is what happened to the value of Sterling before and during the start of Great Financial Crisis from 2007 through to the end of 2009:
Why is this good for UK-based clients? Because at exactly the time when assets worldwide will be falling in price, the effect of major currency movements will most likely be working in your favour. This has a dampening effect on price falls. Here’s what happened during the same period to UK and US investors holding the same index, the S&P 500:
Source: Monmouth Capital
US investors saw falls in their main index of over 50%; the exact same assets held by a UK investor, unhedged, saw losses of just over 30%, a 20 percentage point difference. (It’s the other side of the coin to the Apple example I gave at the beginning of this article.)
Owning overseas assets turned out to be a “natural hedge” for Sterling-based investors during what was the greatest financial crisis for eighty years.
And lastly, while it may not seem intuitive, even exposure to volatile Emerging Market currencies may mean benefiting from long-term trends in your favour.
Unlike the dollar, yen or Swiss franc, Emerging Market currencies are absolutely not “safe havens” with relatively small fluctuations. On the contrary, some of them have experienced epic, drawn-out blow-ups, lurching from crisis to crisis.
But here, too, there is a trend that can be positive for UK investors. We believe there is a strong case for emerging market economies to continue to grow faster than developed countries over the long run. Typically, when they do develop and move beyond the “emerging” stage, it is not just their economic output that increases; their currencies usually appreciate, too, such as the Thai Baht and Korean Won against Sterling since the “Asian Crisis” of 1998:
An allocation to emerging markets by a UK-based investor is made in order to benefit from faster economic growth; if this transpires, currency movements are likely to boost returns.
What can we take from this quick look at currencies?
Currency movements can significantly reduce or enhance returns from overseas investments.
Forecasting currency markets accurately and repeatedly is fiendishly difficult.
You can pay to remove the impact of currency moves from your investments.
UK investors are better off not doing so. Structural, long-term trends work in their favour.
- FS
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