Should you buy a currency hedged overseas investment fund?

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Should you ever hedge? Currency moves can have a big effect on returns from an overseas fund


Buying a fund that invests overseas but mitigates negative currency moves rather than just them riding out sounds like a good idea on the face of it.

But individual investors are routinely warned off using the ‘currency hedged’ versions of funds, because it involves making tough judgement calls that professionals often get wrong.

Don’t fancy yourself a currency trader, because it’s a notoriously hard job to do, is the general message from experts – and it’s a persuasive one if you are a long-term, buy and hold investor.

Should you ever hedge? Currency moves can have a big effect on returns from an overseas fund

Yet investing experts acknowledge there are exceptions, when taking a short or medium-term view on how a currency will fare might make it worth using a hedged fund for a period.

Even then, you need to have an exit strategy, and be willing to bear the extra costs involved for a time.

We look at the impact of currency trends on investment returns, and why and when you might consider a currency hedged fund – or just do the simple thing and keep more of your portfolio in UK investments.

How big an effect does currency have on returns?

‘The basic rule is if the pound goes up it detracts from your overseas holdings,’ says Darius McDermott, managing director of Chelsea Financial Services.

‘If you are in a US fund and it’s up 1 per cent and sterling is up 1 per cent versus the dollar you get zero return.

‘If the same fund is up 1 per cent and sterling is down 1 per cent versus the dollar you get a return of 2 per cent.’

He says an example of UK investors missing out due to currency movements occurred in 2006, when American funds were up 15 per cent, but sterling was also up 15 per cent, so they saw no return.

‘The currency is a huge part of the total return of your fund in the shorter term,’ says McDermott.

Why are individual investors typically told to steer clear of hedged funds?

Darius McDermott: 'The basic rule is if the pound goes up it detracts from your overseas holdings'

Darius McDermott: ‘The basic rule is if the pound goes up it detracts from your overseas holdings’

Using hedged funds is not recommended for long-term investors saving into pension or Isa funds because it is so difficult to predict currency movements, according to McDermott.

They are affected by many variables over the long term, including central bank interest rate policies but also single political events like Brexit, which has influenced trading in sterling since the referendum in summer 2016, he explains.

McDermott says that although his firm didn’t think the UK would vote to leave the EU, it did still take a small dollar position for its own funds before the referendum, and this rose in the following weeks as the pound fell.

Similarly, last September when the pound was weak, it did use some hedged funds to reduce the potential risk that it might suddenly strengthen.

But McDermott stresses that these were professional and selective business decisions, and he has never considered hedging his own personal portfolio, because currency movements get ironed out over time.

He also notes that fund managers are not currency experts so they mostly prefer not to hedge, and nearly all global funds are unhedged since they involve so many different currencies.

Jason Hollands, managing director of Tilney, says hedged versions of funds, or share classes – they are typically tagged with an H on fund tables – were primarily created for use by professional investors such as wealth managers and multi-asset managers.

They allow industry investors to neutralise the potential effects of foreign exchange movements when investing in overseas stock markets, he explains.

That is useful when they believe a currency is likely to depreciate over a particular time horizon, and offset underlying investment returns, he goes on.

‘This typically means they are suited to more sophisticated investors with a short to medium term view on a particular currency and therefore such share classes are not aimed at retail investors or those taking a long-term buy and hold approach.’

Should investors consider it anyway, and if so when?

‘The typical answer to the question ‘should you buy the currency hedged version of a fund invested overseas’ is no,’ says FundExpert.co.uk boss Brian Dennehy.

‘To do so means predicting currency moves – this is very difficult and even the currency experts aren’t great at it, so don’t pretend to yourself that you know better.’

But Dennehy says there are exceptions, and offers two examples – though he emphasises they are ‘definitely exceptions’.

1. ‘Global bond funds have two sources for return, bonds and currency. Most such funds don’t try and manage the currency and if they do try aren’t obviously successful.

‘One exception is the highly experienced M&G Global Macro Bond team.’ Find out more about the conventional version of the fund here, and the hedged version here.

2. ‘If the source of overseas growth is derived from an expectation of local currency weakness. For example, a small number of years ago Japanese exporters looked decent value, and expectations of a weakening yen made them look even more attractive (as it would make the exporters’ goods cheaper overseas).

‘As a sterling-based investor into the shares of such Japanese companies you might have made money, but could have lost those gains on conversion back into sterling, as sterling was strong relative to the yen.

‘So you might have bought a hedged Japanese equity fund.’

Jason Hollands of Tilney says hedged Japanese funds worked particularly well for investors for a period, because after Prime Minister Shinzo Abe took office in 2012 his reform programme led to a sharp depreciation in the yen.

Measures included encouraging the central bank to carry out a massive money printing exercise and to cut interest rates to a record low.

But Hollands warns investors who use a hedged investment fund to try to exploit situations such as this need to take a view on when to exit the strategy, because currency slides don’t last forever.

‘Anyone remaining in an overseas fund that hedged returns back into sterling when the pound plummeted in 2016 as a result of the uncertainties created by the Brexit referendum, would have got seriously burned,’ he notes.

Jason Hollands: Anyone remaining in an overseas fund that hedged returns back into sterling when the pound plummeted after the Brexit vote would have got 'seriously burned', he says

Jason Hollands: Anyone remaining in an overseas fund that hedged returns back into sterling when the pound plummeted after the Brexit vote would have got ‘seriously burned’, he says

Hollands says the chart below showing the performance of the Man GLG Japan Core Alpha fund tells the Japanese story quite well.

‘The hedged version proved really useful from the end of 2012 following the election of Shinzo Abe to the summer of 2015, delivering significantly higher returns.

‘However, as the UK woke up to the prospect of the EU referendum, fortunes reversed.’ 

Hollands says the chart below showing the performance of the Man GLG Japan Core Alpha fund tells the Japanese story quite well

‘The hedged version proved really used from the end of 2012 following the election of Shinzo Abe to the summer of 2015, delivering significantly higher returns. 

‘However, as the UK woke up to the prospect of the EU referendum, fortunes reversed.’

Man GLG’s Japan Core Alpha fund – conventional and hedged versions 

Performance of the conventional version (red) versus the currency hedged version (blue) in pounds over the past 10 years (Source: Tilney and Lipper)

Performance of the conventional version (red) versus the currency hedged version (blue) in pounds over the past 10 years (Source: Tilney and Lipper)

If you expect the pound to strengthen because of Brexit, would that make it an exception?

‘Unless and until there is sustained strengthening of sterling, and where there is good reason to expect that trend to persist over years, don’t bother trying to second-guess currencies – it is no more than a guess,’ warns Brian Dennehy of FundExpert.co.uk.

Hollands believes that political uncertainties are lifting now the election is over and Brexit is going to happen.

And he says that even though the future trade relationship with the EU is yet to be determined, there is arguably scope for sterling to continue recovering, particularly versus the US dollar.

Yet he still cautions against hedging on cost grounds.

‘If you own a US index tracker and believe sterling could rally further against the dollar from current levels, then there might be a case for switching into a currency hedged fund such as the iShares S&P 500 Monthly GBP Hedged UCITS exchange traded fund which converts returns back into sterling.

‘However, before doing so you need to weigh up the fact that currency hedging comes at a price and is not a free feature.

‘In the case of this ETF the ongoing charge is 0.20 per cent which is a quite a premium to the sister iShares S&P 500 UCITS ETF which charges a mere 0.07 per cent.’  

So how else can you mitigate currency risk?

Most investors are unlikely to have strong short to medium term views on currency movements, so they should use conventional overseas funds and accept that currency volatility is an inherent risk factor, according to Hollands.

Instead, the simplest way to mitigate currency risk in a portfolio of funds is just to keep a reasonable slice in UK funds, he adds.

‘Many investors have avoided or reduced exposure to UK funds in recent years due to political worries, instead buying global funds, and that does leave them particularly exposed to currency movements.

‘Anyone in this situation, particularly those who sold all their UK funds, should rethink the wisdom of such an approach.

‘In my view, if you are based in the UK and have most of your costs and liabilities in pounds, then it makes sense to have a meaningful weighting to UK investments.’ 

 

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