Investment and currency movements

Investment and currency movements

Photo by Ethan McArthur on Unsplash

Over recent years here in the UK we have witnessed the volatility of sterling against other currencies and lately even the strength of different currencies has come into question.  Whether this is something we as a nation should be worried about or not, the question of how to structure long term investments to take into account future currency movements can be a concern.

When planning for the future, one of the first questions usually asked is in what currency will the expenditure predominantly be in?  Deciding where you are likely to be living or spending the majority of your time is likely to inform in which currency your investments are valued and held.  If you plan to stay in the UK this is most likely to be sterling (I think we can forget about any chance it will be the euro!).

However, this is not necessarily the same, as to where underlying funds are invested.  For example, an investment account might be valued in sterling and pay withdrawals and income in pounds and pence but the assets it contains, if part of a global diversified portfolio, will be in several different currencies.

Exchange rates have historically been volatile and unpredictable but this unpredictability need not cause concern to investors with assets globally invested.

It’s often hard to get one’s head around the complex effect of currency movements and how this might affect investments.  A weaker pound might be good for UK exporters but bad for foreign companies selling goods in the UK.  All else being equal, sterling investors with assets overseas are more likely to gain from falls in sterling against other currencies, while investors in other currencies with UK assets might lose out.

Academic evidence suggests that currency movements are difficult to predict in the short to medium term in a manner that is relevant for making investment decisions[1].  While it’s possible to profit from exchange rate movements by currency trading, trying to do this is highly speculative and similar to gambling. 

At Bloomsbury we don’t attempt to predict currency movements but, because we value the benefits of diversification, our clients’ portfolios are invested on a global basis – holding equities and bonds in other countries and valued in other currencies.  Movements in exchange rates differ from shares and bonds because they don’t produce interest or profits; therefore, they don’t have an expected long-term positive return.

We could try to reduce currency volatility by hedging the currency exposure.  This is similar to buying foreign currency from a bank or bureau de change and including a buy back option (at the same rate as your purchase) on your unused currency.

However, again academic evidence indicates that the value of hedging depends on the asset class and the aim of the strategy[2].  In global equities, hedging foreign currency exposure tends not to reduce return volatility by a significant amount.  Equities are as volatile as exchange rates, so the volatility of an unhedged global equity portfolio is, on average, dominated by the volatility of the underlying equities, not that of the currency movements.  The long term returns from a hedged or unhedged equity portfolio are largely indistinguishable from each other. 

In global bonds though, hedging currencies is an effective way to reduce return volatility because currency returns are more volatile than the returns of typical high quality short term fixed income assets which our clients’ portfolio hold.  If the currency exposure is unhedged, the currency could be mostly responsible for the volatility in a fixed income portfolio.

The objective of holding the global bonds is to reduce the volatility of the equity component, so keeping its volatility low is important.  We therefore generally hedge the currency exposure of our global bond exposure with the goal of reducing volatility.  However, we don’t see the same volatility reduction benefit for our international equity exposure and so, we don’t hedge currency exposure in this asset class.

So, if the effect of currency movements on long term investments, causes concern, our approach is not to reduce global exposure but to embrace the diversification that global investing provides. Try not to be overly anxious with short or medium term currency movements in equity exposure, to offset this perhaps you may consider using an investment fund or funds that hedges exposure in defensive or bond assets.  Having done this, leave your portfolio alone and worry about things that you can control.

Charles

This blog is intended for information purposes only and no action should be taken or refrained from being taken as a consequence without consulting a suitably qualified and regulated person.  Your capital is at risk when investing.  Foreign currency exchange and interest rates may cause the value of your investments to fluctuate which may not be in your favour.

[1] Meese, Richard A. and Kenneth Rogoff. 1983. “Empirical Exchange Rate Models of the Seventies: Do They Fit Out of Sample?” Journal of International Economics 14 (1): 3-24.

Lustig, Hanno, Nikolai Roussanov, and Adrien Verdelhan. 2011. “Common Risk Factors in Currency Markets.” The Review of Financial Studies 24 (11): 3731-3777.

Rogoff, Kenneth and Vania Stavrakeva. 2008. “The Continuing Puzzle of Short Horizon Exchange Rate Forecasting.” NBER Working Paper no. 14071.

[2] Gerard O’Reilly and Jed Fogdall 2012 “Currency Returns and Hedging Decisions” Dimensional Fund Advisors.