Currency hedging: How currency can impact investment returns, and how we manage it

At a glance

• If an investor holds assets in a foreign currency, movements in the value of that currency can impact investment returns.
• Currency risk can be managed using 'currency hedging'. Currency hedging refers to the management of currency exposure, or currency risk, associated with owning foreign assets.
• Our team uses both hedged and unhedged exchange traded funds (ETFs) in order to increase or decrease exposure to moves in foreign exchange rates.  

What is currency risk?

The foreign exchange (also known as FX or forex) market, is the global market for currency trading. It is enormous. Trillions of dollars are traded in the forex market around the world on any given day. It is open 24 hours a day, five days a week and operates across all time zones.

The FX market performs a vital role in the smooth operation of international trade, but some investors also trade currencies to help manage risk or seek profit. 

If you have ever converted some money for a holiday abroad, you may have seen the value of the pound sterling moving around against a list of other currencies. That is an example of the FX market in action.

The number of factors that can influence how one currency moves relative to another is huge. A few key reasons a country might see its currency rise or fall in value are below.

• Economic strength – If investors expect an economy to grow or shrink
• Interest rates – Higher relative interest rates can mean a higher yielding currency. The higher yielding currency can be attractive to foreign investors, assuming inflation remains under control (which leads us to...)
• Inflation – If domestic inflation (inflation within the borders of a country) rises or falls, particularly more than expected
• Political stability – If the stability of a country's government is in flux 

These are only a few factors that could alter investor perceptions of a currency's value. The important thing for investors to understand is that if you are buying an asset denominated in another country's currency, you are indirectly investing in that currency.

Example:

Let's say you as a UK investor buy shares in an imaginary American company. The company is listed on the New York Stock Exchange, and it trades in US dollars. Two years later, the share price for this US company has risen by 20%, and you decide to sell the holding. 

Over the same timeframe, the value of the pound sterling has fallen by 10% against the US dollar. When you sell the US asset – locking in your 20% gain – you will probably then convert the US dollar proceeds received back into sterling (as a UK investor). Because the sterling is now 10% weaker, your return is in fact 10% higher. This is because, in this example, the US dollar proceeds now 'buy' more of the now-weaker sterling. The opposite could also be true, in a scenario in which the currencies had moved in the other direction.

Currency risk is, therefore, the potential for currency movements to impact investment performance. Currency movements – and how they impact portfolio returns – can often be overlooked or misunderstood.

Understanding currency exposure is inherent to the good management of a globally diversified portfolio, and it is therefore a central part of asset allocation decisions. Depending on the asset mix and overall risk, the level of currency risk can be a significant contributor or detractor to portfolio returns.

Currency can contribute to how volatile portfolio performance is. By extension, it can also be an important source of diversification (as we explain later). When markets themselves are more volatile, currency can have a bigger impact on performance and add to the sense of uncertainty. 

What is currency hedging?  

Currency exposure can be managed by using what are called currency 'hedges'. Currency hedging in this instance means taking decisions that provide a portfolio with more, or less, exposure to the movement in foreign currency. 

Currency risk is one of the many things the investment team here keeps an eye on when managing your portfolios.

So how do we manage currency risk?

To explain how currency fits into our portfolio management decisions, it's best to start with an explanation of our strategic asset allocation (SAA). 

We use a core strategic asset allocation philosophy to create and manage diversified multi-asset portfolios with a long-term horizon. Our long-term strategic asset allocation serves as a guide for our managed and fixed allocation portfolios. Our SAA is the anchor of our allocation guidelines and essentially the foundation for our investment universe (the complete set of investment options available to the investment team).

The SAA is built using quantitative tools which use long-term data to help us create stable, robust and attractive portfolios containing assets diversified by regions, sectors and currencies.

The market capitalisation of each region we invest in (its total market value relative to other regions) is crucial to the final construction and management of our SAA framework and every year we reassess this framework with the latest market capitalisation data.

You can think of the SAA as a template for what we believe is a well diversified global portfolio, that should provide a good balance of risk and return in what might be considered 'normal' conditions.

Real life is of course more complicated than that, and as a consequence, the 'live' portfolios are adjusted by the team according to what is happening in the real world. The investment team is constantly assessing market conditions, and making adjustments to our portfolios (less frequently to Fixed Allocation) where needed, to create what we believe is the portfolio with the best balance of risk and potential return. The live portfolio allocation can look quite different to the strategic asset allocation, but is regularly checked against it. 

The SAA comprises several components, and the currency position is outlined in the table below. 

The building blocks of our portfolios are ETFs. If an ETF used in a portfolio adds exposure to foreign assets, it is common practice that the ETF providers offer versions of ETFs that retain the foreign currency exposure, as well as those that hedge currency risk back to a single currency. If you are a UK investor for example, you may wish to use a sterling-hedged version to mitigate your FX risk for that ETF holding. If you are a French investor, you may wish to use the euro-hedged version, and so on. You could also hold both the hedged and unhedged versions, and decide how much of the foreign currency exposure – if any – you wished to keep. 

For example, one of the main components provides our portfolios with exposure to diversified overseas companies that are traded in foreign currencies. The 'neutral' currency position of the SAA is to hedge, or remove, 30% of the currency risk of this portion of the portfolio. This means that when neutral/in line with the SAA, a portfolio assumes 70% of the currency risk of the allocation to foreign companies, with 30% of that currency risk hedged. The other components are denominated in sterling, so it is not necessary.

The strategic decision to maintain some flexibility in FX exposure is due to the potentially diversifying benefits it can add. The investment team might believe, for example, that the outlook for sterling is deteriorating and seek to limit the impact this may have, perhaps by adjusting hedged ETF holdings. In some cases, the dynamics that might support a given region's equity market (domestic or foreign) might also align with those that support the currency. That is to say, dynamics the investment team believe will support a currency might also be positive for that country's equity market.   

Illustration of the strategic asset allocation

Which currencies will I be exposed to? 

The team can reduce or increase this foreign currency exposure, depending on their views on the market. The currencies that the investment team chooses to add exposure to can also vary depending on their view of prevailing market conditions.

In the illustration of the SAA above, the currencies the portfolio would have exposure to would be predominantly the US dollar, with smaller amounts of the euro, Japanese yen, Chinese yuan, Canadian dollar, and other currencies. The exact mix will vary depending on the composition of the underlying ETF that is used to gain exposure to the foreign companies in question. 

Our Head of Investments, James McManus, explains... 

"We manage currency exposure in our portfolios by using both hedged and non-hedged versions of various ETFs, when the underlying assets are denominated in foreign currencies. 

"In equity allocation, we hedge approximately 30% of our foreign equity exposure, although this percentage may vary based on our market outlook. Recently, in response to the tariffs announcement, we adjusted our exposure to the USD, bringing it to a neutral position. This decision reflects our tactical approach to managing currency risks, with the US dollar less attractive than it was at the start of 2025. 

"For our fixed income investments, we primarily hold UK assets, which are not impacted by currency fluctuations. Where we invest in foreign fixed income, such as high yield or emerging market debt, we hedge the exposure to mitigate currency risk." 

As with all types of investment risk, we manage our currency position actively and monitor it closely, weighing up opportunities as data emerges. Remember, if you are uncomfortable with currency risk, our lower risk portfolios have more bond, and less foreign equity exposure, and therefore are inherently less exposed to currency risk. 

Risk warning

As with all investing, your capital is at risk. The value of your portfolio with Nutmeg, and any income from it, can go down as well as up and you may get back less than you invest. 

Past performance and forecasts are not a reliable indicator of future performance. We do not provide investment advice in this article. Always do your own research.