The million dollar sterling question

Since the financial crisis, one of the key trends in UK retail investment has been a hunt for broader sources of income.

Immediately after the collapse of Lehman Brothers in 2008, interest rates plummeted to record lows and stayed there. Banks slashed dividends in 2009, followed by BP in 2010. Many savers who were historically keener on UK equity income diversified into corporate bonds, as did investors who were nervous about gilts and the state of the UK’s government finances.

In the last couple of years, the income picture has become more complicated. Given the weakness of the UK economy, and major wobbles in UK dividend payments, investors started hunting overseas for interest and dividends. As long as sterling stayed weak, an income stream from overseas equities remained attractive. Strong inflows into global equity income funds ensued. As our recent Analyst profiles of the best-selling IMA Sterling Strategic Bond fund sector have demonstrated, a number of funds in the sectors also feature a good deal of overseas instruments.

However, all of the aforementioned overseas strategies have an Achilles heel of bank dividend sized proportions. If sterling strengthens against overseas currencies, the value of overseas income will fall. If sterling strengthens rapidly, its value will plummet.

Anyone looking at the economic stagnation in the UK might reasonably wonder why anyone would want to own sterling, let alone in large quantities. However, currencies are a bizarre, capricious beast. The dollar weakened during the US boom of 2003-06 and soared during the pandemonium of 2008. In spite of chronic financial woes in Japan, it also recently collapsed to a post-war low against the yen. Forecasting currency movements based solely on the strength of an economy is flawed.

There are a number of ways of hedging against unpredictable currency movements. Fund managers can purchase derivative contracts, such as forward agreements to transact sterling and a foreign currency at a set rate, or options to buy currencies at certain prices on particular dates. However, options cost funds a percentage of their assets every year, while forwards require them to set aside collateral – which can balloon in times of extreme market movements. If funds invest in too many derivatives, they can turn into an equity or a bond fund with a derivative overlay – which requires painstaking explanation to investors.

It is revealing that Fidelity, with such resources at its disposal, has decided to launch its recent Global Dividend fund without any initial currency hedging attached – unlike, say, Sarasin, which offers a global equity income strategy hedged back into sterling. Global Dividend manager Dan Roberts says he simply takes currency into account when choosing the underlying stocks, just as he would have to take overseas cashflows into account when running his previous UK equity income products. There are limits, however, to which global equity income investors can take this strategy, as they cannot invest their entire portfolio in sterling assets. If sterling climbs against most other currencies simultaneously, some fund managers may be left with nowhere to hide.

Nick Rice is editor of Investment Adviser