Currency fluctuations are often top of mind for professional and private investors alike. Currency exposure is an important part of a globally diversified multi–asset portfolio, and therefore an important part of asset allocation decisions. Depending on the asset mix and overall risk, the level of currency risk can be a significant contributor to portfolio returns and volatility – as well as an important source of diversification.
We manage currency risk at Nutmeg via the use of currency-hedged exchange-traded funds (ETFs), which effectively neutralise the effect of foreign currency exchange rates over a given time period. This blog digs a bit deeper into currency hedging.
Do my investments devalue if the pound drops?
It’s natural to consider the value of your foreign investments with events like Brexit affecting the value of the pound in relation to other global currencies. While the value of the pound (GBP) continues to be volatile – rising and falling with the news flow – Nutmeg believes a positive end to the long running Brexit process, in which a deal is forged, is likely to result in a rise in the value of GBP. Conversely, a fall would be more likely in the event the UK leaves the EU without an agreement.
It’s important then for investors to recognise and proactively manage the currency risk within their investment mix. At Nutmeg, we take an active view on managing currency risk within our fully managed and socially responsible portfolios. Our investment team actively manage the portfolios’ exposure to foreign currency within the relevant risk level and mix of assets held. This means not only deciding what share of a portfolio’s assets should be held overseas, but also how much of that exposure should be retained in local foreign currency and how much should be ‘hedged’ back into GBP. You can read more about our approach to currency hedging in an older blog, here.
What is a currency hedge?
Currency hedging is simply an investment technique that seeks to protect against foreign currency devaluation harming the value of investments held overseas.
Let’s use a simple example: A core holding in our portfolios is exposure to US large cap companies, via the S&P 500 stock index. These companies are denominated in US dollars (USD) and so their value on a given day also reflects the current exchange rate between USD and GBP (as the value in USD is converted to GBP at the end of each day in customer portfolios).
In this example, if we believed that GBP was likely to weaken, we would be happy to hold the investment unhedged and subject to exchange rate moves. If USD gained against the GBP as expected, then the value of our investment would benefit from this currency movement.
On the other hand, if we believed the value of GBP was likely to rise against USD, then we might seek to partially hedge that exposure. If USD did indeed depreciate against GBP, that fall would be partially neutralised.
An all-in-one solution on a two-way street
Currency risk is a two-way street. Should GBP fail to move in the direction anticipated by a hedge-strategy, then an implicit ‘opportunity cost’ is paid by virtue of the missed benefit of a stronger foreign currency value. Nutmeg minimises this opportunity cost by exercising partial hedges rather than full hedges. And, of course, we size our hedges with close attention to the amount of foreign currency risk suitable for the risk target of the portfolio.
As well as the implicit opportunity cost just described, there are two explicit costs to hedging. The first is that hedged ETFs have slightly higher fund fees to account for the extra management processes required of the ETF provider. The second cost relates to the way in which the hedged currency price is set; it relates to the difference between short–term interest rates in the two markets. But the key point is that this second cost accrues daily in the ETF price itself.
Think of hedging with ETFs as an all-in-one solution that is incredibly cost effective, utilising the economies of scale that many major ETF providers offer to provide a low cost, risk managed and accurate way of managing currency risk in portfolios.
Nutmeg expects that the pound will remain volatile as the politics plays out around Brexit, and our team will continue to actively manage the currency mix as seen to be appropriate; not least to manage risk and ensure portfolios remain well diversified.
Risk Warning: As with all investing, your capital is at risk. The value of your portfolio with Nutmeg can go down as well as up and you may get back less than you invest. Forecasts are not a reliable indicator of future performance.