The significant fall in the British pound sterling (GBP) has attracted a lot of attention and concern from investors using it as their base currency. But what are the concerns, and does the decline impact investors' end returns?
Many UK expat investors invest across global markets rather than simply in British shares and bonds. Investing internationally can bring many advantages to a portfolio. It can provide exposure to different economic cycles, inflation rates, and interest rates, as well as increased diversification. But it also exposes you to exchange-rate risk.
What is currency risk?
Currency risk is the impact of exchange rates on your overseas investments. For example, if you own US equities and the US dollar weakens against the pound by 5% (assuming US stock market prices remain the same), the result is that your US equities’ value falls by 5% when their value is converted back into sterling.
However, it can work in your favour too. If the dollar strengthens by 5% against the pound (the US stock market is again unmoved), then your US equities rise by 5% when their value is converted into sterling.
A GBP-dominated global equity fund will be copying the same process. It will need to convert the GBP to all of the currencies that it owns shares in, as all foreign investments are priced in different currencies—for instance, US dollars, euros, or the Chinese renminbi.
The MSCI ACWI index has 23 developed-market currencies and 24 emerging-market currencies. If a fund were to replicate this index, it would need to convert into all the relevant currencies to buy the shares. The performance of the underlying shares will be reflected in the fund returns, but the movement of the currency will also enhance or detract from the overall returns.
A point on the FTSE 100
The composition of the UK FTSE 100 is heavily skewed to three sectors: financials, energy, and consumer staples. The index is also dominated by global large-caps like HSBC and Royal Dutch Shell, which earn most of their revenue abroad. Around 75% of FTSE 100 firms' earnings come from overseas, which means that they, too, are heavily exposed to currency risk.
When the pound falls, those foreign earnings are worth more in pounds, boost the share price of the major players in the index, and boost your FTSE 100.
However, a FTSE 100 company really owns a basket of global currency exposures because it is difficult to know (unless you are in the company) how much hedging back to GBP the treasury operations of those 100 companies actually undertake and when. It's not something an investor can manage.
What about hedging the currency?
You could choose GBP-hedged funds if you're a UK GBP investor who wants to eliminate currency risk as much as possible. Appropriate funds will generally have the term “GBP Hedged” in their names, but always check the product's factsheet or webpage to make sure. If you can't find any reference to GBP hedging in the fund's name or literature, assume it isn't hedged. You'll also notice that hedged funds are often a little more expensive than their unhedged counterparts. That's because the hedge itself incurs costs.
FX-hedged investments might be helpful if you have a short time frame and a very specific goal for funds in a particular currency.
However, in the long run, FX-hedged investment will deliver a return that is reduced by the cost of the hedging activity because there is the cost of the transaction, and nobody has complete knowledge of what hedging activity the foreign (or domestic) business that you own undertakes.
To think otherwise means speculating on one currency outperforming another in the long run. Trying to be consistently successful in guessing the long-term performance of currencies is extremely difficult, if not impossible.