Protecting your portfolio
Investors should not try to predict currency movements, but you can act to protect your portfolio. Investing in foreign securities, while potentially a good thing for your long-term portfolio, may continue to pose new threats for investors.
As more people broaden their investment portfolios by expanding into foreign stocks and bonds, they must also bear the risk associated with fluctuations in exchange rates. Fluctuations in these currency values, whether the home currency or the foreign currency, can either enhance or reduce the returns associated with foreign investments.
Inherent investment risks
Several levels of investment risks are inherent in foreign investing: political risk, local tax implications and exchange rate risk. Exchange rate risk is especially important, because the returns associated with a particular foreign stock must then be converted back into sterling.
Portfolio risk
The political climate of foreign countries creates portfolio risks because governments and political systems are constantly in flux. This typically has a very direct impact on economic and business sectors. Political risk is considered a type of unsystematic risk associated with specific countries, which can be diversified away by investing in a broad range of countries.
Taxation
Foreign taxation poses another complication. Just as foreign investors with UK securities are subject to UK government taxes, foreign investors are also taxed on foreign-based securities. Taxes on foreign investments are typically withheld at the source country before an investor can realise any gains. Profits are then taxed again when the investor repatriates the funds.
Currency risk
Finally, there’s currency risk. Fluctuations in the value of currencies can directly impact foreign investments, and these fluctuations affect the risks of investing in non-UK assets. Sometimes these risks work in your favour, other times they do not. But the reverse is also true: if a foreign stock declines but the value of the home currency strengthens sufficiently, it further dampens the returns of the foreign position.
To hedge, or not to hedge
Investors may reduce the risk of loss from fluctuations in exchange rates by hedging with currency futures. Simply stated, hedging involves taking on one risk to offset another. Some investors may be comfortable with unhedged currency exposure, meaning they are happy to have the opportunity to profit from currency moves in their favour and don’t mind risking currency losses.
It’s also important to note that, over the long term, currency fluctuations tend to be ironed out, and it is very rare to get the extreme currency movements we have seen recently – things tend to revert to the mean over the long term.
Underlying fund holdings
However, if you don’t want to take on this currency exposure, you could choose to invest in a currency-hedged share class. In this type of share class, currency fluctuations are lowered by using financial instruments called ‘derivatives’ so that any future exchange rate movements between the currency used by the investor and that of the underlying fund holdings do not materially affect the level of the fund.
Currency hedging can never be fully accurate. If you invest in a hedged share class, you will only minimise your currency exposure, not remove it completely. Also, as well as avoiding the downside, when you invest in a currency-hedged share class, you will miss out on any positive returns from currency movements.
Other currency exposure
Another consideration is where companies generate their revenue. Many companies, particularly the larger ones, are exposed to other currencies, due to the international nature of their operations. So it is important to check whether this is the case for many of the stocks held by a fund in which you are interested. You should also note that currency hedging does not result in any investment management charges to investors, but the fund does bear the costs and expenses of the currency hedging transactions.
Currency risk is a consideration when investing, but one which lessens if invested for the long term. It can be mitigated with the use of a currency-hedged share class but also by ensuring that your portfolio of investments is always diversified, so that you are never over-exposed to any one particular risk.
INFORMATION IS BASED ON OUR CURRENT UNDERSTANDING OF TAXATION LEGISLATION AND REGULATIONS. ANY LEVELS AND BASES OF, AND RELIEFS FROM, TAXATION ARE SUBJECT TO CHANGE.
THE VALUE OF INVESTMENTS AND INCOME FROM THEM MAY GO DOWN. YOU MAY NOT GET BACK THE ORIGINAL AMOUNT INVESTED.
PAST PERFORMANCE IS NOT A RELIABLE INDICATOR OF FUTURE PERFORMANCE.
