In spite of confirming the UK’s departure from the single market, Theresa May’s speech last week prompted a significant rally in sterling. It was testament to the unpredictability of currency investing. Yet currency movements have had a profound impact on investor returns in 2016 and may do again in 2017. Should investors seek to accommodate currency movements in their portfolio?
The impact of currency for investors in 2016 is not in doubt. For the calendar year, a USD investor in the MSCI World index would have seen a return of 5.32%, a sterling investor would have seen a return of 25.62%. The extraordinary political landscape was felt most keenly in currencies – the weakness of sterling, the strength of the US Dollar, plus difficulties in selected emerging market currencies such as the Mexican Peso.
When Currency Falls Mean Profit
Currency fluctuations were good news for those with a significant global bias to their portfolios, but it left the returns from sterling investments looking lacklustre by comparison. It also skewed the returns in certain global funds. It flattered those managers with very high US weightings, for example.
2017 promises similar turmoil. Elections across Europe, the rise of populism, Trump’s first 100 days and the ongoing negotiations on Brexit are all likely to be felt in currency markets. In its 2017 Investment Themes and Opportunities white paper Mercer said: “Political surprises, protectionism and trade tensions also create the potential for substantial currency volatility so investors should have a clear policy on hedging currency risk.”
However, this is easier said than done. Gavin Haynes, investment director at Whitechurch Securities says: “Currencies are notoriously difficult to predict. Investors shouldn’t be blinded by the returns they received on overseas funds this year. If the UK economy continues to be robust, sterling could rally, but there could be losses the other way.”
Equally, investors also need to consider that there may also be hedging going on behind the scenes within funds. For example, Charles Luke, a manager on the Murray Income fund, says: “We have some borrowing in the trust and we have some companies listed overseas. We aim to match the currency of the debt to the currencies of overseas companies to provide some balance.”
However, the majority of the trust is unhedged. Luke says that it naturally seeks out companies with diversified revenues, so is not over-exposed to movements in individual currencies. It is unlikely the managers would hold a company solely exposed to the Mexican domestic economy, for example.
Stock Selection Curbs Currency Risk
There will also be some natural hedging in a portfolio’s asset allocation. For example, some managers sought to minimise their exposure to sterling weakness by investing in larger capitalisation companies. This worked well to mitigate losses. Disaggregating a fund’s exposure to currency is not always easy.
Nevertheless, there is a case for hedging to match nearer-term liabilities or to reduce volatility. David Jane, manager of Miton’s multi-asset fund range, says:
“The recent extreme volatility in currencies and lack of certainty argues for us to have a much higher degree of sterling exposure than we might have had in the past. While this means we might have foregone some of the upside from the weak pound over the past year we consider the avoidance of loss and minimisation of volatility a greater priority.”
There are a number of ways to hedge currency, each with its own cost and drawbacks. Given the disparity of potential outcomes for currency in the year ahead, Haynes is currently building in a mix of hedged and unhedged funds in his main global exposures: “A large number of groups now offer hedged and unhedged versions of their major active funds.” He has also been careful with his fund selection to ensure that the performance of funds within his portfolios has been driven by the skill of the fund manager, rather than simply currency considerations.
Passive Funds to Play Currency
ETFs are another option for those looking to hedge currency. They are cheaper than traditional derivatives-based hedging options, such as futures contracts, and open to a broader range of investors. They are two main types: There are those ETFs dedicated specifically to currency trading pairs or indices. These were extremely popular in 2015 in the wake of major currency events, such as the Swiss withdrawing its Euro peg and fluctuations in the Yen. Then there are also hedged and unhedged versions of the major index ETFs.
Currency ETFs allow investors to take a bullish or bearish view on individual currencies, but investors need to be careful how they are constructed. For example, a US Dollar ETF may be measuring the US Dollar against a basket of currencies, including the Euro, Yen, Canadian Dollar or Swiss Franc. As such, it may not offer a ‘clean’ hedge against sterling/USD fluctuations.
Investors also need to take note of how frequently the ETF is rebalanced. Currencies are extremely volatile, yet some ETFs only rebalance monthly. This may be inadequate to hedge currency risk fully. On the other hand, frequent rebalancing may add to the cost, which will become more important with longer-term hedging strategies.
Equally, the level of hedging needs to adjust to fluctuations in the price of the underlying asset. If the value of a holding goes up, an investor may find themselves under-hedged. For example, they may have hedged £100,000, but if the value goes up to £120,000, £20,000 remains unhedged and investors need to adjust.
Currency is a fickle friend. The returns available from successful currency management can be seductive and there is an increasing range of products open to investors who wish to try and manage currency. However, a balanced portfolio across geographic regions can be just as effective as specific hedging.
