In a global portfolio, currency can be an opportunity or a threat. Either way, you bear currency risk when investing in any overseas asset. In this week’s passive blog, in association with Lyxor ETF, we look at how you can manage currency risk in a global portfolio.
What is currency risk? Why does it happen?
Currencies fluctuate daily, usually as macro-economic events happen, such as interest rate changes, economic data releases and geopolitical events. Hurricane Irma prompted the US dollar to fall, whilst Trump’s election helped it soar. If you’re investing in overseas assets or even assets with a sizeable overseas exposure, currency moves could make a big difference to how your portfolio performs.
Dividends are also subject to currency risk. Even in the UK, many companies pay their dividends in US dollars, including income stalwarts like BP, HSBC and Rio Tinto. When the payments are converted to sterling, the amount you receive will depend on the exchange rate – if the pound is strong, the less you are going to be paid, consequently eating into returns.
Even so-called safe haven currencies are not necessarily ‘safe’ from currency risk. In January 2015, the Swiss National Bank depegged the Swiss franc from the euro, sending it soaring by 30%. This hit shares– the Swiss Market Index fell 7.6%, excluding dividends, that same month.
However not all consequences of currency movements are negative; they can sometimes be positive. For example, sterling dropped in the aftermath of the Brexit vote, which benefits the likes of Glaxo or Rio Tinto indirectly when overseas earnings are converted into pounds. In these instances, stocks that pay dividends in euros or dollars are a good bet. A weak pound also improves the competitiveness of UK exports – foreign tourists are likelier to visit the UK, foreign investors are more likely to look for British assets and then there are the UK firms who earn profits abroad that will benefit.
A passive solution
As an example, the Lyxor US TIPS GBP Monthly Hedged (DR) UCITS ETF costs 0.2%, while the Lyxor US TIPS (DR)UCITS ETF is only 0.09%. The chart above shows the long term performance of the indices tracked by each fund – as you can see the difference can be sizeable. Without the currency exposure, the hedged index is much less volatile, behaving much more like a defensive asset. The unhedged has greater chance for performance, but greater possibility of loss too.
Of course, this illustration is historic and the past is no guide to future returns. But currency risk can be a choice – not an obligation. Currency hedged ETFs are a handy tool to have in an ever changing economic climate.
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Source for fund and charge data: Lyxor ETF, market data Bloomberg, correct as at 17th October 2017. Chart correct as at 17 October 2017.
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