When investing internationally, foreign currency is an important risk factor to consider. It can affect your returns and rock the boat.
The first thing that comes to mind is: Let’s remove currency risk and “hedge” our portfolios. But is this the correct way to go about it?
As UK investors we have seen some big GBP swings lately.
In 2016, the British pound lost almost 1/4th of its value against the dollar! What do I care, you may think. Well, if you were invested in USD companies or held USD then you’d be 23% richer just from currency alone.
The opposite happens when GBP gets stronger. Let’s say you invest in Apple and make 5%. If the British pound gains 10% against the dollar then you’re -5% worse off! You’ve actually lost money in GBP terms. Sure your fancier GBP can buy more holiday martinis but you’re poorer in local terms.
Ok, does this all mean that we just invest internationally, pray for a fall in GBP and job done? Not really. Personally, I want to balance my foreign currency exposure so that I don’t need to worry about what happens with the sterling.
I live and earn in the UK, pay taxes here, own UK property etc. As a result, I already have huge exposure to the local currency, before even investing a penny. It would be prudent to seek some foreign currency exposure in case GBP fell. (I know right? Just saying…)
We all know the picture is not so rosy for GBP but the good thing is that we can do something about it!
In this post I’ll try to answer some valid questions:
- How should I go about investing in foreign currencies hassle-free?
- Should I hedge my investments?
- How much GBP return is attributed to currency movement and how much in “real” market returns?
- How can I take advantage of a falling or a stronger British pound?
Regardless of how good your investments are, what matters is your purchasing power where you live. In other words, can you buy more things after your investments are sold?
Why currency forecasting is a fool’s errand
Let’s get this thing out of the way, early. Predicting currency movements is a coin toss. Even worse if you do it consistently because of trading fees. Unless you’re a professional forex trader with at least one PhD in mathematics (in which case, I’d like to hear more) you cannot consistently profit from currency movements.
The truth is, that similarly to stocks, all public information is incorporated in the currency price. You may think Brexit is coming and the GBP is at risk, so you should buy some EUR on Revolut. But so thinks everyone else. All the public information about how “bad” as an investment GBP is has been priced in, already. This is why GBP/EUR is 1.09 and not 1.40 at pre-referendum levels.
You may think that 1.09 is at an all-time low and can’t go lower, therefore, you better only invest in British stocks or sell your foreign investments. But millions of professionals who do this for a living are “betting” in the forex market and there’s little chance you as a casual investor can succeed in this game.
You have other leverage you can use against professionals, the best one being time on your side and no need to quarterly report like they do. But currency forecasting ain’t one of them.
Currency also doesn’t produce any earnings or pay any dividends for that matter. Sure it reflects the local economy, the interest rates and other economic factors but currency itself is not ‘profitable’.
So leave currency forecasting to others and focus on things you can control. Like portfolio construction and currency exposure that makes sense for you.
How to get foreign currency exposure when investing
The good thing is that it’s super easy to invest in other currencies. When you invest in foreign stocks, ETFs, mutual funds, your money is converted to foreign currency automatically.
See this very useful chart from Vanguard:
A UK-based investor holding international funds has a double benefit. Not only they diversify against the local economy going south but they also hold foreign currency without doing any extra work (like exchanging money themselves).
Overall, a great way to get currency exposure is to invest in a global tracker like FTSE Global All-cap. You get some USD, EUR, JPY, and all sorts of foreign currencies without sweating about it.
Note: The base-currency of the fund has nothing to do with currency exposure. The fund's price is shown in a specific currency, regardless of its underlying investments. For example, the fund may be based in Ireland and have a EUR price tag. But this only matters for reporting purposes. Your money will still be converted in USD if the fund holds Apple. What really matters is the word "hedged" that when present means the currency exposure is zero. That's for those who want to make sure this fund does not have any currency exposure and it's not very common. Whether a fund is hedged or not is quite obvious, it often is in the fund's title too as it's very important info! Most funds aren't hedged.
Should I hedge my stocks or bonds?
The bonds part of your portfolio is the low-risk one. Therefore it makes sense to hedge your bonds if they are international. Today, most bond funds are hedged or only invest in local bonds (UK gilts). The stocks or stock ETFs part of your portfolio is the riskier one and this is where it makes sense to take the foreign currency risk.
If bonds return 2% but currency moves by 5-10%, that defeats the whole purpose. Therefore, investing in bonds should be hedged. If you care about the volume of the ups and downs (volatility) then you should definitely hedge your bonds. This is because currency movement accounts for the majority of the volatility in bonds but play a very small part in stocks. See images below:
Now if you’re thinking of hedging your stock portfolio as well, it’ll make little difference over the long-term. A good resource is this currency-hedging paper by Vanguard, albeit it refers to a USD investor (link).
As you can see, it all breaks-even over 20 years. Hedging also has an extra cost for the fund manager which then gets passed to you, the investor. So it’s a bit more expensive and gives another reason to avoid it in the stock part of your portfolio.
On average and in the long-term, the decision to hedge or not to hedge does not seem to lead to systematic long-term gains.
Why a falling GBP is not that bad
If GBP loses its value against other currencies, this is not all bad for you, the UK-based investor. For starters, if you do have investments in foreign currency then you get back more than you invested, all else being equal.
Then the production of local goods and services is cheaper for foreign companies and investors. Therefore, your local market becomes more competitive in global terms. It’s one reason China keeps devaluing its currency and maintain manufacturing strength. But this is harder as more Chinese enter the middle class. As living standards improve and the currency gets stronger, exporting becomes more expensive for the foreign buyer.
Then there’s the “smoother crash factor” to consider. USD is king and the GBP usually falls in times of stress. See the below global returns of MSCI All World index in local currencies. See how in 2008 a USD investor felt a -42% crash but a UK-investor in the same fund dropped only by -19%! Quite brutal for them, not so much for us.
The same thing happened during the Coronavirus market crash in March. A US investor dropped by -33% whereas a British investor in the same fund dropped by around -20%.
Sure, I couldn’t deploy my new GBP money because the pound had dropped from 1.40 to 1.16 against the dollar, but my “old” money was doing better than expected.
Therefore, a falling GBP in times of panic is not that bad because the crash landing is softer. You kinda have a small parachute. It’s also an added benefit because it reduces the chance you sell out of panic.
Foreign currency investing guidelines for UK investors
Having international stocks or funds offers extra diversification because they’re based in foreign currency. When GBP gets stronger you can buy more foreign goods/services but your foreign investments fall in GBP terms. The opposite happens when GBP falls. Since 2004, sterling investors in US equities have enjoyed cumulative gains about 30% higher than their US dollar counterparts. I don’t think this will continue and as we saw earlier, currency fluctuations even out in the long term.
But having this foreign-currency exposure in the riskier part of our portfolio makes total sense. It can actually reduce the overall risk. Especially if you live and work in the UK.
Bonds are the low-risk part of our portfolio and currency movements can be so big relative to the bond returns. They defeat the whole purpose so most investors (including myself) do hedge them.
If you want to move abroad and GBP falling is your main concern, you should think twice about buying property. That’s because when you’re putting down a £50k deposit on a £500k house, you’re not only risking £50k but the entire cost of the property. So your currency risk is £500k, regardless of the size of your deposit.
Returns come from productivity gains and population growth. The biggest part of your returns will come from the asset allocation (and luck, timing) not from currency. Don’t put the cart before the horse!
Investing in a country because it’s currency will get stronger is hard to predict. You should have some very good reasons for doing so. Otherwise, just hedge your bonds, let your stocks run and carry on 🙂