InvestmentsMay 17 2013

Investment strategy: How to play the currency game

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ByAlistair Cotton

Thousands of funds are available that give investors exposure to different regions, countries and asset classes at low cost. This provides an opportunity to diversify portfolios in a way that historically was only available to institutional investors.

IFAs have additional reasons for looking toward foreign markets in search of return. One of the direct effects of monetary easing by western central banks is the suppression of yield. From the safest assets and government bonds, through to corporate bonds and equities, central bank intervention has depressed returns in domestic financial markets.

Increasing exposure to fast-growing emerging markets or buying American large-cap stocks makes sense when the UK is bouncing in and out of recession and the eurozone crisis continues to depress economic activity across the continent.

Investing directly into a fund or via an ETF are two ways to gain exposure to any asset class or region you desire. Investing in general involves certain risks investors are well aware of – market, credit and liquidity risk in particular – but investing abroad brings currency risk into that equation as well.

Beware underlying currencies

Currency risk is underappreciated by retail investors. The vast majority of firms investing outside a home market will not hedge currency exposure, instead solely focusing on the fund’s returns. But taking returns in sterling while investing in dollars immediately puts you at the mercy of the exchange rate between the two currencies, which, depending on how it moves, will have a significant impact on the overall return of the investment.

For example, the eurozone crisis presented patient investors with attractive opportunities to capture value. Italian stock prices have fallen precipitously since the crisis engulfed Italian and Spanish debt markets. ECB action has backstopped both governments but the non-result in the Italian election is keeping investors wary about adding risk in that country.

The dividend yield for the Italian market is 4 per cent, against 2.7 per cent for the rest of the world. This sounds attractive until you factor in the value of the euro. If it were to lose just 1.3 per cent against the pound the extra return is wiped out.

With many funds offering no currency hedging whatsoever and simply focusing on picking stocks or bonds to maximise returns, currency risk is difficult to avoid. It is important to be mindful of whether or not hedging is part of the fund’s strategy before you invest. It is also important to consider which currencies the fund is exposed to. It could be a single currency, like the euro or dollar, or it may invest across a broad range of currencies.