Currency risk for investors

Investing internationally introduces exposure to exchange rates, which is a separate source of return and risk from the underlying assets.

How it works

The mechanics.

Holding a foreign asset means the return in your own currency depends on both the asset's performance and the movement of the exchange rate.

A foreign asset that rises ten per cent while its currency falls ten per cent produces roughly no return to a domestic investor.

Which means currency movement can dominate the outcome over shorter periods.

Equities versus bonds

Where the treatment differs.

For equities, currency volatility is typically smaller than equity volatility, which means it adds proportionally less to the total.

Currency exposure also provides some diversification, since currencies frequently move in ways unrelated to equity markets — and a domestic currency frequently weakens during domestic economic stress, which cushions foreign holdings.

Which is why unhedged global equity exposure is common and defensible.

For bonds, the position is different: currency volatility is typically much larger than bond volatility, which means unhedged foreign bonds are dominated by currency movement rather than by the bond return.

Which is why currency-hedged bond funds are the standard recommendation.

What hedging does

And what it costs.

Hedging uses forward contracts to remove the currency effect, returning the local-currency performance of the asset.

The cost is not merely the fee: the forward rate reflects the interest rate differential between the currencies, which means hedging a currency with lower interest rates than your own produces a positive carry and hedging one with higher rates produces a negative one.

This can be material and changes with rate differentials.

Plus the operational cost within the fund.

Which means hedging is not free and its cost varies over time.

The purpose test

Which resolves most cases.

If the holding exists for stability — bonds providing ballast — currency volatility defeats the purpose, so hedge.

If the holding exists for long-run growth — equities — currency volatility is a smaller proportion of the total and provides some diversification, so hedging is optional.

If the money will be spent in a foreign currency, holding it in that currency reduces risk rather than increasing it.

And for money needed soon, currency risk should be removed regardless of asset class.

Home currency and future spending

The point people miss.

Risk is relative to what you will spend the money on.

Someone who will retire in their own country and spend in their own currency faces currency risk on foreign holdings.

Someone who intends to retire abroad faces the reverse: holding entirely domestic assets is the risky position.

And someone whose spending includes substantial imported goods and energy has some natural exposure regardless.

Which means the answer depends on your circumstances rather than on a general rule.

The long-run picture

Worth understanding.

Over very long periods, exchange rates have some tendency to revert towards relative purchasing power, though the periods over which this operates are long and the deviations are large and persistent.

Which means currency risk may diminish over very long horizons and is substantial over the horizons that matter for most decisions.

Studies of the effect of hedging on long-run equity portfolios generally find modest differences in return with somewhat lower volatility when hedged.

Practical implementation

What most investors should do.

Hold global equities unhedged, which is the default in most global equity funds and is defensible.

Hold bonds hedged to your own currency.

Hold cash in your own currency.

Consider hedged equity share classes if currency volatility would cause you to abandon the holding, which is a behavioural justification.

And check what your existing funds actually do, since the hedging status is frequently in the share class name and is easy to hold accidentally either way.

The costs of conversion

A separate practical point.

Buying assets denominated in another currency involves a conversion, and platform exchange rates frequently include a margin that is not disclosed as a fee.

Which can be a substantial cost, particularly on regular purchases.

Options: using funds denominated in your own currency, even where they hold foreign assets; using platforms with competitive conversion rates; and holding foreign currency balances where the platform permits, to avoid repeated conversion.

Checking the conversion charge is worthwhile and is frequently overlooked entirely.

What not to do

Where currency becomes speculation.

Attempting to time currency movements, which has the same forecasting problems as any other market and arguably worse.

Holding foreign currency as an investment, which produces no return and carries volatility.

Changing hedging policy in response to recent currency movements, which is performance chasing applied to exchange rates.

And using leveraged currency products, which regulators restrict for retail investors for good reason.

General information only, not investment advice. Investments can fall in value and past performance does not indicate future returns. Consult a regulated financial adviser.