Investments & currencies

26 October 2021

Every investor has a “base” currency, i.e. the currency any investment would naturally be measured in. An investor’s base currency tends to be the currency of the country where she lives, earns and spends money or, in case of expats, the currency of the country where they intend to return or permanently relocate to.
Can you decide to invest in your base currency only? Yes, but exposure to foreign exchange movements is unavoidable if you want a diversified portfolio. And even if you invest in a domestic company you will take on currency risk if the company conducts large amounts of business in foreign markets.
So what considerations are needed to understand and deal with currency risk?

Currency vs investment performance

The performance of an investment that is denominated in a currency other than your base currency will always be made up of two components: the investment intrinsic performance, and the investment currency performance. If the house you bought in the UK a year ago for 100,000 GBP is now worth 110,000 then the MWR (or IRR) is equal to 10%. But if 100,000 GBP were worth 100,000 USD (your base currency) last year and 105,000 USD now, then the current value of your house is 115,500 USD, implying an MWR of 15.5%. 10% is the intrinsic performance, 5.5% is the currency performance. Currency movements can compound – or reduce – intrinsic performance (and with Exirio, we measure these two components for you).
It is possible to hedge currency risk and largely reduce the exposure to a non-base currency, but for most individual investors and most investments this is either too complex or too costly: so if currency exposure is inevitable, an investor needs to be at least aware of it and realize that the investment performance will be consequently impacted – for the better or the worse.

Investment listing

Some investment products are listed in different currencies. For example, there are several ETFs tracking the S&P 500 that are denominated in both USD and GBP. If your base currency is GBP, should you buy the GBP one? Unless the documentation says the ETF is hedged, the answer is probably no. You are investing in US companies, buying their shares in USD and fully exposed to USD-GBP currency risk regardless of the ETF currency listing. Choosing a GBP-denominated version of this ETF only means that when you buy it and when you sell it, the ETF provider will execute the FX transaction for you, at whatever market levels will be prevalent at the time. They will charge a fee for this service (which may not be that obvious to find), and you will not have reduced your currency exposure.

Hedged investment products: hedged ETFs

However, many ETFs are indeed available in a hedged format, i.e. offering a reduction of the underlying currency risk.
Take a non-hedged ETF investing in Japanese equities (denominated in Japanese yen): investing in it would leave American investors exposed to the yen movements against the US dollar. I would need to exchange dollars for yen today to buy the ETF, and then do the reverse upon selling the ETF. And thus remain exposed to the decrease (or increase) in value of the yen against the dollar between purchase and sale date. But if a hedged version of the same ETF exists, I can achieve the same investment exposure without having to care about the dollar movements vs the yen.

Should I always buy hedged ETFs?

The short answer is no. Hedging is not free and although hedged ETFs offer the cheapest hedging option, if you are paying for something you need to decide whether it’s worth it. It is for you to decide whether you want currency risk or not: as we saw earlier, currency fluctuations can amplify your intrinsic return. Also, sometimes it may actually not make sense to hedge. Take the MSCI World ETF for example:

This ETF lets you take exposure to the stock markets of 23 industrialised countries, and it implies exposure to 14 different currencies. The first thing to remember is what we saw earlier: even if this ETF is denominated in USD, it doesn’t mean it’s hedged. What counts is your exposure to the currency of the underlying securities. 60% of your currency exposure is to the US dollar because 67% of the ETF’s securities are traded in that currency on the US market. 7% of your exposure is to the yen, and so on. But could you buy a hedged-version of it? Yes, there is a GBP-hedged one. But should you? That largely depends on your investment horizon.

Short-term vs long-term investment

Longer-term investors may actually gain from currency risk. Financial theory – and evidence – indicates that global equities automatically hedge each other out in the long run, with rising currencies being offset by falling ones: in other words, exchange rate fluctuations have a decreasing impact on equity returns as time horizons lengthen. The idea is that currencies reach equilibrium over time, and therefore exchange rate fluctuations tend to net out. Currency risk may even reduce the volatility of your holdings by reducing the correlation between the returns of different assets in different currencies.
But if you may need the funds you are considering investing sooner rather than later, the hedged option may be worth looking at.

Conclusion

Currency risk is real, but sometimes it may be possible and/or worth it to reduce it.
And if your investment return is directly affected by currency fluctuations, on Exirio you can clearly identify and separate intrinsic from currency performance, so that you can make better-informed investment decisions.

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