4 things to know about currency hedging

When it comes to managing your investment portfolio, most investors spend a lot of time thinking about regions, sectors and asset classes and a lot less time thinking about currency exposure and currency hedging. This is a shame because currency risk can have a material impact on your investment returns over time and it’s a risk that can be easily managed by currency hedging. In this Insight, we explore what currency hedging means and why it matters.

Picture this; 12 months ago, you booked a hotel in Rome for a week, locking in a price of €1,000 to be paid at the end of your stay. On 16th February 2022, this price was equivalent to around £840 (GBP:EUR = 1.19). Sterling has depreciated a little since then, though. So today when you’re checking out of your hotel, it is going to cost you around £884 for the same €1,000 bill (GBP:EUR = 1.13 as at 16/02/2023). Of course you could argue that in this example it’s only an extra £44, it’s not a big deal. But currency moves can have the same impact on your investments over time so getting a handle on currency risk is important.

Currency hedging is a tool to reduce the impact of currency fluctuations

In 2023, every well diversified investor will have international assets within their portfolio. It could be international bonds, equities or foreign-currency-denominated alternatives (for example, gold is usually priced in US dollars). This means that every well diversified investor also has foreign currency exposure within their portfolio.

Currency hedging can be a useful tool for investors to try to reduce the impact of currency fluctuations within their portfolio. It is usually achieved by using derivatives to ‘balance out’ your currency exposure. For example, let’s say you’re buying a US dollar-denominated asset (i.e. you’re buying USD), you might also buy an option contract or a futures contract to sell the same amount of USD for a pre-agreed price in the future. This will, in effect, mean that you are USD neutral at that future point in time.

To use our earlier example of the hotel in Rome, you’d enter into a futures contract in February 2022 to buy €2,000 in February 2023 to cover your hotel and your spending money. At the time, you’d lock in a future exchange rate so that in February 2023 you know exactly what your holiday is going to cost you.

With investing, currency hedging means that you can experience the pure fluctuations in the price of the underlying investment asset (e.g. the stock, bond, property, etc), without a change in the exchange rate impacting the valuation. You are going to experience the full force of the change in share price for L’Orèal, for example, regardless of whether the euro strengthens or weakens compared to the pound over time.

Currency hedging doesn’t always work in your favour

It’s important to highlight here that accurately predicting currency trends and changes in exchange rates is extremely difficult, if not impossible, for the professionals. It’s even more difficult for personal investors who don’t have access to the same information and tools as the professionals.

In our Rome-Hotel example, currency hedging would work in your favour, as the pound has depreciated over the last 12 months, meaning that you would have locked in a better price 12 months ago than you would have done today. If, however, the Euro had weakened against the pound over the same period and the currency had moved the other way, you would have been better off not hedging your currency exposure and paying for the hotel in February 2023.

The same is true with investing; because currency hedging means that your returns are ‘pure’ demonstrations of the performance of the underlying stock and in general, you would be protected from headwinds (i.e. if your domestic currency appreciates) but you’re also not going to benefit from tailwinds (i.e. if your domestic currency weakens).

For example, let’s say that you own $5,000 of Apple stock. This is currently worth around £4,160 (GBP:USD = 1.20 as at 16/02/2023).

• If the Apple share price remains the same, but GBP weakens (let’s say to USD 1.10), you’ve immediately made a return, as your $5,000 is now worth approximately £4,545.
• If GBP strengthens, let’s say to USD 1.30, and the Apple share price remains the same, you’ve just lost value in GBP terms as your shareholding is now worth around £3,846.
• If you were currency hedged, you would have seen no change in the value of your portfolio, as the Apple share price has remained the same, $5,000.

Currency hedging doesn’t need to complicate your strategy

We know, there’s a lot to unpack here (and we’ve barely scratched the surface). Never mind the fact that personal investors don’t easily have access to things like derivatives, futures contracts or currency swaps.

The good news is that as a personal investor, you don’t always need to be able to access hedging tools. Often, fund managers will be hedging their currency exposure as part of their overall strategy. They do this to give their investors pure access to the assets in their portfolio. This means that you don’t need to take out your own hedging strategy.

If you are particularly keen to ensure that your exposure is either hedged or unhedged, then you should check the fund information documents to confirm the manager’s stance and strategy on this. Some funds do also offer the option for you to choose between a ‘hedged’ and ‘unhedged’ share class when picking your investment (like we do on TILLIT).

You don’t always need to be hedged

So, when do you need to be mindful of your currency exposure?, you ask. As with many investing questions, the answer depends.

There are lots of investors who do not give currency hedging any consideration at all; accurately predicting currency moves is notoriously difficult and some investors argue that currency risk is just an inherent part of international investing. Other investors argue that you achieve a ‘natural hedge’ by having diversification in your currency exposure. If you are purely investing in Europe, for example, your returns are going to be much more sensitive to the GBP:EUR exchange rate than if European assets make up, say, 10% of your overall portfolio.

Typically, investors should be most mindful of their currency exposure when they have a significant exposure to a particular currency or when they have exposure to a market with a history or potential for a more volatile currency. For the former, let’s say that you’re investing in European equities. If your European equity exposure is 100% of your portfolio, then your returns are going to be significantly affected by changes to the GBP:EUR exchange rate and you might want to manage this currency exposure.

For the latter, this is most true when investing in emerging and frontier markets. Investing in these markets gives you exposure to economies which are less developed and/or regulated, or experiencing increased political instability. This doesn’t always have to be bad, but when an economy goes through a period of transformational change for whatever reason (domestic or international pressures), the currency may move significantly very quickly. In some cases it can even take years for it to recover. This may in turn, have an adverse impact on any potential returns to be made from that investment. Therefore, even very long-term investors should bear this in mind before investing.

Overall, currency hedging is be a useful tool for investors to separate currency risk from the pure returns of the underlying assets in a fund or portfolio. Currency is another risk that is important to be mindful of when building your portfolio but in many cases, fund managers implement hedging within their strategies. Either way, it’s good to know how it works and why it matters so that you can make informed investment decisions that are aligned with your goals and views.

Date of publication: 21st February 2023