Diversify if you’re worried about exchange rates

21 November 2018
Image


We usually only think about currencies when it comes to holiday spending money. However, currencies – or more specifically exchange rates – can also have an impact on our investments

Brexit: a recent example

A good example of the impact currency movements can have on our investments came when we held the EU referendum.

The day of the vote, the London currency markets closed with the Sterling/US dollar spot exchange rate at 1.4947. This means that £1 bought you $1.50. The political fallout and resulting uncertainty of the ‘Leave’ result caused the pound to fall sharply in value. When the markets opened on the Monday morning, the exchange rate had fallen to 1.3445, meaning you would now only get about $1.34 for your £1. In holiday terms, we had less spending money but what about in investment terms?

As an investor in the UK investing in a US company, the returns you will ultimately receive will be influenced by movements in the Sterling/dollar exchange rate too. If Sterling weakens against the dollar, your returns will be enhanced. If it strengthens, returns will be diminished.

Let me explain. Darius’s US equity fund (a fictional fund investing in US companies) has shares worth $5 each. The exchange rate is £1/$1.50, so each share is worth £3.33. You invested $500 (or £333) before Brexit and got 100 shares. Assuming the share price is still $5 after Brexit, but the exchange rate is now £1/$1.34, $500 is now worth £373, so you gained £40 as a result of the weakness of Sterling.

The de facto global currency

There are other currencies in the world, but the US dollar tends to dominate when it comes to our investments. This is because it is the de facto global currency and makes up 64% of all known central bank foreign reserves. So it’s important to know a couple more things about the greenback if you are a global investor.

Firstly, the US dollar is seen as a safe-haven currency. At times of extreme stock market stress or geopolitical uncertainty, it is the asset everyone turns to. In 2008, when the global financial crisis took hold, investors rushed to buy the US dollar at the expense of other assets. So while global stock markets fell, the value of the US dollar increased.

Secondly, the US dollar can have a major impact on emerging markets – mainly because a lot of emerging market economies have dollar-denominated debt. So if the dollar strengthens, their loans become more expensive to pay back.

When there is extreme stock-market stress, everyone turns to the US dollar

Protecting your portfolio from currency risks

Over the long term, currency fluctuations tend to be ironed out and it is very rare to get the extreme currency movements we have seen in recent years.

But if you want to minimise your currency exposure, you can choose one of three options:

  1. Invest solely in UK companies (but note that some will have revenues from overseas still).
  2. Invest in an overseas fund with a ‘currency-hedged’ share class if one is available (currency fluctuations are lowered by using financial instruments called derivatives).
  3. Make sure your portfolio is diversified, so any one currency has less of an impact.

Personally, I would pick option three as the easiest way to achieve diversification is to choose a global equity fund.

A few I like, which have a good spread of investments across the globe, include Fidelity Global Dividend, Standard Life Investments Global Smaller Companies and F&C Global Smaller Companies trust.

The first invests in larger companies that also offer a good yield. It currently has around 30% invested in the US, 22% in Eurozone countries, 20% in the UK, 8% in Japan, 8% in Switzerland, and the rest in Asia.

The other two invest in smaller companies and have larger exposure to the US (40%-plus), but also have more exposure to Asia and emerging markets right now.

Past performance is not a reliable guide to future returns. You may not get back the amount originally invested, and tax rules can change over time. Darius’s views are his own and do not constitute financial advice.

Darius McDermott is managing director at Chelsea Financial Services and FundCalibre