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.
Single currency exposure is naturally easier to account for and manage; multi-currency becomes more difficult as the number of currencies grows but as a rule of thumb hedging into US dollars will usually protect investors to the greatest degree possible because of the dollar’s status as the world’s reserve currency.
Hedge your bets
In normal economic conditions the trade-off between allowing the fund manager to focus on maximising returns and adding another element to the strategy by hedging exposure is a value judgement an investor can, and should make. In an era of currency wars, hedging is essential.
Fund managers are waking up to the increased volatility in the foreign exchange markets by offering hedging options within their suite of funds. Aberdeen Asset Management, for example, offers hedged share classes to reduce currency volatility for two of its bond funds. The Aberdeen Global Select Euro High Yield Bond fund is hedged in euros and the Aberdeen Global Select Emerging Markets Bond fund is hedged in US dollars.
The dollar’s status as a reserve currency is a bonus for investors looking for returns in less liquid markets. Many emerging markets currencies are linked to the US dollar, mitigating the need to hedge in local currency and allowing access to the deep and liquid US forward market.
Investors looking at specific shares or bonds should use customisable contracts that allow for hedging currency risks. Forward contracts could be used to hedge a position in an individual share or bond for the duration of the holding period of the asset.
Specialist currency brokers, like ourselves can set these up at low cost and offer the capability to roll over positions should things not work out as expected. Currency ETF’s are another viable option, offering an attractive way of hedging at a low cost, with the flexibility to trade out of the position at any time.
Uneasy about quantitative easing
Countries that are planning on extended monetary stimulus should come with a health warning for investors. Monetary easing is still viewed in the market as a negative for currency. As such, sterling, US dollar and the euro should be treated with caution.
Developed countries that have avoided the worse of the multiple crises, like Australia, Canada and the Scandinavian countries, are less likely to see a sharp move downwards by central bank action and therefore these currencies have less need to be hedged.
Currency risk can be significantly reduced, but never eliminated. Even investing in domestic equities carries some currency risk, with many large multinationals exposed to currency fluctuations across the globe. Encana, Canada’s largest natural gas producer, saw first-quarter profits wiped out after recent currency losses. Even blue chip brands like Coca-Cola suffer currency risk, deriving large revenues from emerging markets that need to be hedged back into US dollars.
The recent financial crises have presented numerous opportunities for investors to make sensible additions to portfolios by investing overseas. However, in an era of unprecedented central bank intervention in the financial markets, hedging your currency exposure has never been more important.
Alistair Cotton is senior analyst at Currencies Direct
