Currency is often referred to as a separate and distinct asset class, with funds specifically dedicated to profiting from relative currency returns compared with an investor’s base currency – sterling in this case. But across mainstream asset classes, exposure to international fixed income and equities also carry non-sterling currency exposures that can be both a source of return and also a significant risk.
When investing in international holdings, investors need to consider both the expected return from the asset class and also from its underlying currency. Simply put, do you see the currency as a contributor to returns or a significant risk that could overwhelm the return from the asset class? We believe the latter is a key risk for most UK investors.
For instance, emerging market currency appreciation was a significant driver of returns from emerging market equities during the boom years. Between September 2002 and July 2008, emerging market currencies gained 40.4% against the dollar, according to the JP Morgan Emerging Market Currencies Composite index. Since then, the majority of these gains have been reversed.
On the rebound
While the market consensus is still towards further easing from the Bank of England and continued weakness of sterling, we believe the strength of the UK recovery is being understated. A rebound in the pound – even just back to the levels at the start of the year ($1.63) – could result in losses in international assets that would overwhelm the gains from the asset class, particularly in fixed income.
Currency exposure can also introduce significant volatility to a holding, something that may prevent its inclusion in a low-risk portfolio. Removing the additional volatility from currency fluctuations can allow a wider set of international exposures to be used for lower-risk clients.
So why should investors use currency-hedged products?
Many discretionary managers find it problematic to put a currency overlay across a client portfolio, both from an operational but also a suitability perspective. Using funds that hedge currency risk is far simpler, although the choice of vehicles is still relatively limited and largely focused on equities.
Mitigating risk
The most common asset that is currency-hedged is Japanese stocks. Since 11 October last year, the Topix has rallied by 70% in yen but 41% in sterling terms. The iShares MSCI Japan GBP-hedged exchange-traded fund eliminates yen currency risk and has a total expense ratio of just 0.05% pa more than the unhedged iShares version, although, admittedly, the iShares unhedged ETF is the not the lowest cost Japanese ETF available in the UK by some margin.
The investment product universe continues to expand, allowing non-institutional investors access to the most exotic asset classes and almost unlimited geographical coverage using vehicles such as ETFs.
Clearly, currency risks need to be carefully understood before investing. While the number of currency-hedged products continues to grow – for example, iShares recently launched three fixed-income funds hedged to the euro – sterling-based investors need a broader range of products to mitigate currency movements. A rebound in sterling could be one of the biggest risks to your portfolio.
