Currency and its impact on investments

We usually only think about currencies when it comes to planning our holidays. Where should we get our euros or dollars? How much will we need? Should we get travellers cheques, cash, a pre-paid card or a combination of each?

However currencies, or more specifically exchange rates, can also have an impact on our investments. A great (and extreme) example of this was when the UK voted to leave the EU – or ‘Brexit’ as it is known.

Brexit impact on sterling

Before the EU referendum, on Thursday 23rd June 2016, the currency markets closed in London with the sterling/dollar spot exchange rate at 1.4947, which means £1 bought you roughly $1.50. The next day, the shock of the Brexit vote had a major detrimental impact on the pound, as the uncertainty over the outlook for the UK economy – and political fallout – made the UK less attractive to overseas investors. When the UK markets opened on the morning of Monday 27th June 2016, the exchange rate had fallen to 1.3445, meaning you would now only get about $1.34 for your pound. So in holiday terms, we had fewer dollars to spend than before.

Let’s look at this in terms of investments. If you invest in a US company (or fund of US companies), the returns you will ultimately receive will be influenced by movements in the sterling/dollar exchange rate. If sterling weakens against the dollar, your returns will be enhanced compared to the dollar return when your investment is converted back into sterling.

For example, American Toys (a fictional company) has shares worth $5 each and you are interested in buying it. The exchange rate is $1.50 /£1, so each share is worth £3.33. You buy 100 at a cost of $500, or £333 in sterling terms. Sometime later, assuming the share price is still $5, but the exchange rate is now $1.34/£1, $500 is now worth £373, so you have gained £40 as a result of the weakness of sterling. If the company pays a dividend, this will also be worth more when paid to you in sterling.

Read more: Where to find dividends outside the UK

Closer to home, UK dividends have also been affected. Many UK companies, especially the larger ones, get a significant amount of revenue from abroad and have dividends which are paid in dollars and euros. These dividends too will have increased in value once converted back into sterling.

Similarly, if exchange rates had moved in the opposite direction (with the sterling strengthening against the dollar) your subsequent returns would then look lower.

What can you do to protect your portfolio from currency risks?

Some investors may be comfortable with unhedged currency exposure, meaning they are happy to have the opportunity to profit from currency moves in their favour and don’t mind risking currency losses.

It’s also important to note that, over the long term, currency fluctuations tend to be ironed out and it is very rare to get the extreme currency movements we have seen recently – things tend to revert to the mean over the long term.

However, if you don’t want to take on this currency exposure then you can choose to invest in a currency-hedged share class. In this type of share class, currency fluctuations are lowered by using financial instruments called derivatives, so that any future exchange rate movements between the currency used by the investor and that of the underlying fund holdings, do not materially affect the level of the fund.

What are the drawbacks of currency hedging?

Currency hedging can never be fully accurate. If you invest in a hedged share class you will only minimise your currency exposure, not remove it completely.

Also, as well as avoiding the downside, when you invest in a currency-hedged share class you will miss out on any positive returns from currency movements.

Another consideration is where companies generate their revenue. Many companies, particularly the larger ones, are exposed to other currencies, due to the international nature of their operations. So it is important to check whether this is the case for many of the stocks held by a fund in which you are interested.

You should also note that currency hedging does not result in any investment management charges to investors, but the fund does bear the costs and expenses of the currency hedging transactions.

Summary

In conclusion, currency risk is a consideration when investing, but one which lessens if invested for the long term. It can be mitigated with the use of a currency-hedged share class, but also by ensuring that your portfolio of investments is always diversified, so that you are never over-exposed to any one particular risk.