When investors are invested across regions and asset classes, they can be left exposed to different currencies and their associated risks should their value depreciate.
Understanding how currencies interact and how their performance can potentially affect a portfolio’s capital growth – or eat into income – is important.
Recognising the reality of currency risk is very different to knowing how to protect a portfolio from its consequences. Avoiding potential downside through exposure to overseas currencies – or indeed taking advantage of currency risk – could be the difference between an underperforming portfolio and a range of investments that outperform markets.
Gavin Counsell, multi-asset fund manager at Aviva Investors, explains: “Currency movements can work for or against you: if the overseas currency appreciates versus your domestic currency, returns will be enhanced, and if it depreciates, returns will be reduced.
“The size of the currency depreciation could mean that it completely offsets the returns of the underlying asset class, potentially resulting in a negative overall return.”
Mr Counsell adds: “It is important to look at the portfolio as a whole as currency can be a useful way of adding diversification and some protection in adverse scenarios. For example, if you have emerging market assets in your portfolio and are worried about the potential impact of rising US interest rates, you may want to have exposure to US dollar assets to provide some balance. Conversely, if overseas currency risk is dominating the portfolio, then hedging is worthwhile.”
Eoin Murray, head of investment at Hermes Investment Management, says: “To be protected from any downside risk associated with currency exposure, investors can elect to hedge [or remove] that risk, either fully or partially.
“The optimal hedge ratio can be calculated for any asset or group of assets, and is likely to differ according to the nature of the asset [equity versus bond] and with respect to the investor’s investment horizon [short versus long].”
Sterling investors will be aware the currency has had an eventful 12 months. The pound was the worst-performing major currency in 2016 as the shock outcome of the EU referendum sent its value slumping.
Despite a subsequent rally, sterling has yet to recover meaningfully as a hung parliament and the start of the government’s Brexit negotiations with the EU continue to weigh. But a depreciation in the value of the currency has buoyed the UK’s main market, the FTSE 100, as companies with overseas revenues benefit from the cheaper pound.
Mr Counsell says: “Since the Brexit vote sterling has depreciated significantly against the dollar, falling as much as 18-19 per cent by mid-January. Looking further back over five years, the pound is around 25 per cent down against the dollar. As such, on some models sterling is looking cheap.”
The question now is whether the pound will fall further, which is only likely to be answered as the Brexit negotiations unfold.