Lost in translation- how currencies can affect investment returns

Posted by Liz Rees in Portfolio management category on 05 Feb 16


Currency and Hedge Funds

How do currency movements affect returns from overseas investments?

The table below, included in our recent market commentary, reminds us of the significant impact that a weak currency can have on your annual returns. It is evident that in 2015 hedging your Euro exposure would have been a good strategy as it lost ground against sterling whilst the reverse was the case for the Japanese Yen and the US Dollar.

Calendar year 2015
% total return
MSCI
World
S&P
500 
FTSE
All Share
FTSE
Euro First 300
Nikkei
225
Shanghai
Composite
Local currency 1.3 0.8 1.0  8.5  9.1  9.4
Pound sterling 3.3 6.6  1.0  3.0  13.3  10.6
  Source: FE Analytics
 
The considerable disparity between currency adjusted returns from different markets has been partly attributed to the divergence of Central Bank monetary policy in major economies. However, we should remember this is just a snapshot in time and making judgements about future currency trends can be even more difficult than trying to time equity investments! The next table illustrates how hedging currency exposure to the Euro and the Yen would have been beneficial in the first half of 2015 but not in the second half of the year. 

Total Returns  FTSE Eurofirst 300 Nikkei 225
  H1 2015 H2 2015 FY 2015 H1 2015 H2 2015 FY 2015
Local currency  13.0 -4.0 8.5 16.0 -5.9 9.1
£ sterling 3.2 -0.2 3.0 11.9 1.2 13.3
  Source: FE Analytics
 
The poor performance of the Euro of late has been attributed to the Eurozone lagging behind other countries in its agenda of interest rate cuts and implementing Quantitative Easing (QE).  The Yen has strengthened considerably since mid-2015, following a long period of weakness, which could be due to its perception as a ‘safe haven’ in Asia following the devaluation of the Renminbi by the Peoples Bank of China.

Since the start of 2016, Sterling has weakened against all 3 major currencies after the Bank of England made it clear that UK interest rate rises have been deferred until the economic outlook is clearer. Meanwhile, the US Federal Reserve delivered the first rate rise in a decade in December.

Looking beyond short term movements

Longer term charts also paint a mixed picture. Looking at a 5 year time-frame, for example, the Yen and the Euro lost 33% and 12% respectively against the Pound but the US dollar gained nearly 6%. 

Resolutions

However, if we consider the movements over 10 years), as illustrated in the next chart, all these currencies appreciated against the Pound with the US dollar +16%, the yen +14% and the euro +7%.

Resolutions

If I’m concerned about currency weakness in my chosen market what can I do? 

You could consider a hedged share class. However, although these have become more popular in recent years with a number being added, they are still not widely available and many leading fund providers do not offer them at all. Providers with a reasonable range of hedged share classes include Schroders and JP Morgan and they are most common in the European and Japan IA sectors.  To search for the full range of funds with hedged share classes on the Willis Owen platform simply type ‘hedge’ into the search box in our Fund Space facility. 

What are hedged fund share classes?

A hedged share class aims to protect your returns when translated back into your ‘home’ currency by the use of financial instruments such as forward contracts. Currency hedging can never be completely accurate, so if you invest in a hedged share class you will only minimise your currency exposure, not remove it completely. Currency hedging does not result in any additional Annual Management Charges to investors but the fund will bear the costs and expenses of the currency hedging transactions.

Moreover, it is important to remember that you will only benefit if the overseas currency which you are hedging weakens. If it should move in the other direction you will lose out from any currency gains that may occur. For example, if you invest in a European equity fund hedged to sterling and the Euro strengthens against the Pound you will not benefit from this foreign exchange rate movement as you are not exposed to it. Of course, if the euro depreciates against sterling you will not suffer the negative impact of this movement.

A non-hedged share class has the opposite effect and your returns will be enhanced if the currency to which you are exposed strengthens and you lose out if it depreciates. Most investors are comfortable with unhedged currency exposure given the difficulty of forecasting currency trends. 

Have hedged share classes done better than unhedged ones? 

Most hedged classes have not been around for 10 years so it is difficult to quantify the long term outcomes. The table below compares the performance of each share classes across a number of funds from JP Morgan (as they have one of the widest ranges of hedged classes).  Unsurprisingly, given the currency trends highlighted above the hedged classes have been most effective for Japan and European funds in protecting returns in Sterling terms.

Total Return Share
Class
JPM Europe
Dynamic Acc.
JPM Japan
Acc.
JPM Global Equity
Income Inc.
JPM US Equity
Income Inc.
2011 Hedged N/A -0.2 N/A 7.8
Unhedged N/A 0.7 N/A 8.7
2012 Hedged 21.7 -7.6 12.0 8.6
Unhedged 21.8 -6.9 11.2 5.6
2013 Hedged 42.3 57.5 24.3 32.6
Unhedged 37.8 38.6 19.8 29.6
2014 Hedged 8.7 8.6 8.5 14.7
Unhedged 1.2 1.3 9.3 21.4
2015 Hedged 12.9 22.9 4.0 -2.6
Unhedged 8.5 28.3 6.3 2.3
  Source: FE Analytics

We can also see that that selecting a good fund manager can be just as important, if not more important, than choosing a hedged share class. For example, in the 3 year period shown below, opting for one of the hedged classes available in the European sector would have undoubtedly enhanced your Sterling returns but there is also a wide divergence between performance of managers whichever fund class you choose.

Total return
%
31.12.2012 -
31.12.2015
FP Argonaut
European
Enhanced Income
I Acc
Artemis
European
Opportunities
I Acc
JPM Europe
Dynamic
Ex UK
C Acc
Schroder
European Alpha
Plus
Z Acc
Hedged  57.4 56.3 74.7 34.2
Non –hedged  40.6 42.7 51.4 20.8
  Source: FE Analytics
 
Can fund managers make hedging decisions for me?

A diversified portfolio is important to ensure you are not over exposed to the trends in a particular currency. Obviously, if you invest in a global fund you will be spreading your currency exposure across a range of markets. Some multi asset funds also take currency positions as part of their investing strategies. 

Very few country specific funds have active hedging strategies within their fund management remit although the manager may take his views on currency into account when positioning the fund. For example, if he expects the local currency of the market to weaken he may increase weightings in sectors and companies which are more dependent on exports. 

A notable exception is Neptune Japan Opportunities fund. Here the fund manager has held a long term hedge on his Yen exposure reflecting his negative view on the currency. The intention to use this approach is laid out in the KIID (Key Investor Information document) with the document section of Fund Space:

The Manager aims to remove the impact of changes in exchange rates between the Yen and Pounds sterling by hedging, a currency transaction which can protect against such movements. However, if exchange rates move contrary to the Manager’s expectations this can have a significant negative impact on the value of your investment.’ 

This strategy has made a very positive contribution to performance over the long term but has been a significant detractor since mid 2015 when the Yen started to weaken. To ascertain whether a fund undertakes active hedging it is important to read the KIIDs on our website.

Conclusions

Currency movements are volatile and not easy to predict. If we look at the Euro and the Yen over the longer term they have both gone through periods of strength and weakness so you would need to taken an active stance on the currencies to really benefit. A hedged class will only provide a one way bet and doesn’t change it’s positioning over time. Therefore it is probably best to think about choosing a hedged class only if you are particularly concerned about protecting yourself from the downside of currency weakness in your chosen market or believe the Pound is likely to exhibit prolonged strength against most other currencies.

Research to identify the most suitable fund for your requirements should be carried out ahead of any decision to opt for a hedged class. However, if you still have a strong view on the future trend of a particular currency it may then be worth seeing if a hedged class is available.

Another factor to bear in mind is that while a weak currency in the region where your fund invests will affect your returns on translation, if the companies held in the fund rely on exports they should benefit. For example, many Japanese businesses are heavily dependent on overseas sales so will be at an advantage when the Yen is weak as their goods will be cheaper abroad and hence more attractive to consumers. This should be good news for their share prices!

The frequent divergence of different currencies supports the argument for ensuring that you have a diversified portfolio by geography as well by asset class. Funds should be seen as a long term investment and just as a country’s stock market performance will vary over economic cycles it is likely that the currency will also fluctuate. By investing in a range of funds across a number of regional markets, or alternatively a global fund or multi asset fund, you should be able to achieve a smoothing out of both sources of volatility over time.

Important Information: We do not give investment advice so you will need to decide if an investment is suitable for you. If you are unsure whether to invest, you should contact a financial adviser.

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