Last year’s stellar returns for UK passive investors came with a snag: What goes up can come down.
Global trackers and all-in-one products like the Vanguard LifeStrategy fund delivered superb returns last year. But this was in large part due to big moves in the exchange rate.
UK listed shares only account for about 7% of the world’s total. Global funds and similar diversified portfolios therefore hold as much as 93% of their money in non-UK shares. These shares are valued in foreign currencies.
As such currencies strengthened against the pound after the EU Referendum, the value of overseas shareholdings soared when translated back into sterling for British investors.
These currency gains came on top of any moves in the underlying stock markets.
So, what’s the problem? Who doesn’t like a 20% windfall gain? Making money from Brexit at least takes the edge off shouting at Question Time.
Also, this so-called currency risk is considered part and parcel of global investing in equities. I’ve explained before how it can diversify your portfolio. When risk works in your favour, it can seem about as scary as a fairground ride.
But how would you feel if the pound suddenly strengthened?
What if your portfolio fell by 20% in a year, even as global markets rose?
A test of passive purity
You might sensibly shrug and say you’d live with it. This is perhaps easier to do after receiving such an unexpected windfall.
Many professional investors and academics say long-term equity investors can probably ignore the swings and roundabouts of currencies and markets, anyway. For various reasons, they tend to work themselves out over time. (I’ll cover why in a follow-up post).
Passive investors especially might baulk at being DIY currency speculators.
Why do you know better than the market about the future of the pound?
What reason do you have to think it’s set to reverse and squash your overseas gains? Full-time professional traders clearly think otherwise.
Monevator contributor Lars Kroijer would say the pound’s weakness reflects the best guesses of countless expert investors putting their money where their mouth is. You bought a global tracker fund to let this combined wisdom decide where your money was best invested.
If you had no edge when you first opted to invest passively and globally, what’s changed?
That’s a very credible attitude. Business as usual is simple, practical, and it keeps the door to active meddling firmly closed. It could be better for your returns, too.
I would offer two counters.
I didn’t sign up for this!
Firstly, the pound’s collapse largely reflects the fear that we might have holed our economy below the waterline with Brexit.
Britain has a precarious current account deficit. We also have an economy reliant on a financial sector that looks especially vulnerable to a clumsy divorce.
We can hope – and try to negotiate – otherwise. But the vulnerability is there.
However some of the pound’s fall might also reflect excessive fear that something very bad could happen, more than the most likely scenarios.
To the (unknowable) extent that’s true, the decline could be overdone due to emotion and political risk. You might wonder whether as an investor you’re likely to be compensated for taking this additional risk?
Secondly, remember the other word for risk – as academics see it – is volatility.
You might intellectually accept research that says long-term global equity investors can usually ignore currency risk.
But that doesn’t make it easy to see your wealth rapidly rise or fall 20% as your country goes through the political wringer.
Such discomfort might make you sell your shares, or at least reduce your rate of saving. It could thus hinder progress towards your long-term goals.
And that’s sub-optimal, as my old maths teacher used to say.
Three responses to currency risk
As I see it, we have three main choices as to how to respond to the sharp currency-based gains many of us have enjoyed recently.
Option 1. Keep on keeping on
A great option and as said I have no argument with it. Changing strategy because something spooks you is not really what passive investing is all about. Fiddling is trying to be smarter than the market.
Perhaps you could think of the risk of your overseas assets falling if the pound strengthens as an insurance policy against a UK calamity. Some analysts reckon the pound could fall to parity against the dollar if Brexit turns ugly.
I don’t expect that, but what do I know? And insurance is never free.
What if you’re a newer saver and investor? Yes, it might turn out you’re buying foreign shares on a relatively costly basis because you’re using temporarily weak pounds. But you won’t remember or notice in 30 years time.
Also, while you haven’t seen the huge big gains from the pound’s collapse enjoyed by older investors with large diversified portfolios, you equally have much less of your lifetime wealth now at risk from a reversal.
You have years of savings ahead of you, and only a little on the table. Why sweat it?
Option 2: Sell overseas holdings, and maybe buy British
Still here? I guess you’re worried the pound will strengthen, and you want to do something about it.
Maybe you’re approaching retirement and you want to lock-in the currency gains, reasoning you’ll be spending pounds not dollars or euros in your dotage.
Or maybe you fancy yourself as the new George Soros, and you think the pound has fallen far enough.
Well, the easiest way to reduce currency risk is simply to sell some of your overseas and foreign-denominated holdings.
You could keep the money raised in UK pounds and bonds. This would also reduce risk in your portfolio overall, as you’d own fewer equities. As The Accumulator wrote last year, it’s worth considering if the gains of 2016 left you feeling vulnerable.
Alternatively, you could reinvest the money raised into UK shares or funds.
This isn’t a terrible idea if you’re an active investor, especially a stock picker like me. Unlike my passive co-blogger, my own portfolio is my precious a hodgepodge that bears little resemblance to a balanced global portfolio. Its active share is turned up to 11! I can always find new UK shares to buy.
But there are big problems, too, with this approach, whether you’re a passive or an active investor.
For one thing the UK market has already rallied on the back of the weak pound.
The FTSE 100 generates about three-quarters of its earnings overseas. Expectations for those overseas earnings have been boosted.
If the pound rose 10-20%, the UK market would probably fall. Swapping foreign shares for a FTSE tracker might be out of the poêle à frire and in to the fuego.
You might try to avoid this by investing in smaller companies that are less reliant on overseas earnings. But they’ve largely recovered, too. You’d also be taking on the risk of doing much worse if we see a deep UK recession from Brexit.
And obviously, you’re getting far, far away from a diversified global portfolio.
Remember, as my own tongue-in-cheek maxim states, risk in investing cannot be created or destroyed. It can only be transformed.
For passive investors especially, I think there’s a better way.
3. Sell overseas holdings, and buy pound-hedged alternatives
At last, the money shot! You could swap into currency-hedged versions of your overseas holdings.
Let me stress I am not saying everyone should immediately do this, especially not to their entire portfolio. But I do believe tilting in this direction is valid.
What is hedging? Hedging for investors has nothing today with shaping your privet into a cock (or a duck, for that matter). Hedging for currency purposes involves putting on a trade that mitigates the impact to your portfolio of changes in foreign exchange rates. A fully currency hedged portfolio would be impervious to exchange rate moves.
If we were big-time fund managers, we might enter into derivative-based Forex1 contracts and options to neutralize the impact of the pound fluctuating on us.
A global tracker fund has about 50% of its money in the US, for instance. So simplistically we could take out a hedge that protects about half our global exposure from movements in the pound/dollar exchange rate. And so on with yen, euros, yuan, krone et cetera…
Now, for reasons I will cover in the follow-up post, it’s not quite that, um, simple. Currencies and economies interact a lot. Currency hedging itself doesn’t take any of that into account. You’re just insulating your portfolio from exchange rate moves.
Okay, understood? Time to tootle down to Canary Wharf to see a man about an expensive currency hedge?
Actually I’m not suggesting that. A far simpler and more passive-friendly approach is simply to invest in currency-hedged funds.
This used to be hard and expensive. The situation today is still not brilliant, but a range of currency-hedged ETFs has made things much easier – and cheaper.
Such funds take care of the hedging for you as part of the package, at the fund management level. You just buy and sell them like any other ETF.
Hedging your overseas bets with ETFs
Consider two ETFs that track a European stock market index:
- The iShares MSCI ex-UK ETF (Ticker: IEUX)
- The iShares MSCI ex-UK Hedged ETF (Ticker: EUXS)
Both ETFs track a selection of leading stocks from European industrial countries, not including the UK.
- The first fund, IEUX, is exposed to the full force of currency fluctuations.
- The second fund, EUXS, is hedged to British pounds (GBP, in finance jargon).
This graph shows how the two ETFs have performed since early January 2016:
The red line shows the gains of the normal ETF, versus the hedged version in blue.
As you can see, the standard version of this ETF has outperformed the currency hedged version by about 20%. That’s entirely down to the weakening of the pound versus the euro.
However if the pound were to rally against the euro, then this situation would reverse.
You can clearly see currency risk in action here. This time it worked to the benefit of a UK investor, but obviously it can go the other way.
There are now quite a few such hedged ETFs available. Have a hunt on JustETF or similar.
Here are a few examples, all hedged to GBP:
- UBS MSCI Australia Hedged ETF
- iShares MSCI Japan Hedged ETF
- UBS MSCI USA Hedged ETF
- iShares MSCI World Hedged ETF
The downsides of hedged ETFs
There’s one obvious drawback of a hedged ETF. If the currency risk doesn’t go against you, then you would have been better with the unhedged ETF!
But leaving aside that hopefully bleeding obvious point, there are other issues:
Higher TERs – Currency hedging is not free. The hedged ETFs I’ve seen tend to have higher annual expenses. They’re not dramatically higher though. For instance the difference between the hedged and unhedged USA ETFs from UBS I linked to above is 10 basis points (or 0.1%) per year.
Fairly new – Hedged ETFs count as an innovation. We’ve no reason not to think they won’t work. But some passive investors prefer to see long track records.
Possibly greater tracking error – The hedging comes at a cost, as said. It also introduces more potential for tracking error, depending on the hedging approach the ETF provider takes.
Smaller Funds Under Management – In all cases I’ve seen, the hedged versions of ETFs have far smaller amounts under management. This might make them more illiquid, which could increase spreads. It could also mean some are more likely to be closed in the future as subscale, which could mess with your plans.
Restricted choice – There are far fewer hedged ETFs out there. There’s no currency-hedged LifeStrategy fund, either. When you buy a hedged ETF version to get exposure to a country or region, it won’t be the cheapest, and you won’t be able to get super choosy about which flavour of index you track.
Clearly the small additional costs associated with a currency hedged ETF will compound the longer you hold it instead of a vanilla version.
If you add hedged ETFs to your strategy for a few years while Brexit sorts itself out, slightly higher TERs won’t matter too much. But over 30 years you will likely pay a noticeable price.
This is important, given that for share investors your returns aren’t likely to be predictably higher due to hedging.
(With overseas bonds the case for hedging is clearer, as we’ll touch on in part two).
To hedge or not to hedge
Personally I’ve moved some of my money into currency hedged ETFs over the past few weeks. Not an overwhelming proportion, but enough to take the edge off in case of a sharp reversal in the pound, and to dampen overall volatility.
Should you do the same? That’s a very personal choice. This article is already extremely long, and I think there are no easy answers. (I’ll point to some academic research in part two.)
For now I’ll cut to the chase and say that in these particularly uncertain times – and after the very steep fall we’ve seen in the pound, to levels not experienced for 30 years or more – I think there’s a strong case for currency hedging 10-25% or so of your equity portfolio.
This is as much to reduce volatility / risk as it is about the pound looking cheap.
Someone is already writing a comment below about how the UK will go into a depression due to Brexit, or how the pound will plummet, or how it won’t, or how passive investors should simply follow the global market and so on.
So before you pile in, note again I am saying currency hedge perhaps 10-25%, as a rough stab.
I am not saying, “hedge your whole portfolio” or “the pound will not fall further” or anything like that.
This sort of allocation would still leave at least 75% of your equities at the mercy of currency risk. That would still provide plenty of insurance from further pound falls. It would remain a largely passive approach to currency allocations.
But, as I say, it could also take the edge off.
Be wary of anyone who makes adamant calls about currency. They may say the pound has clearly bottomed – or that it will obviously fall further.
Nothing is obvious in investing.
Think of all the recent ‘no-brainers’. How commentators told us the US stock market was too expensive to touch as far back as 2012 (it’s now at all-time highs) or how inflation would rocket after QE (still waiting).
The list goes on.
Perhaps the pound won’t bounce against the dollar anytime soon. A pound bought five dollars in the 1930s. It’s been depreciating for a long time.
Maybe £1-to-one-dollar-and-twenty-something is the new normal? Maybe we’re heading to parity?
Not easy!
This is why doing nothing (which really means leaving the genius of the largely efficient market to decide things) will work out best for most people in the long run.
But if you do want to do something in light of the puny pound, I think currency hedged ETFs are worth considering.
- Foreign exchange. [↩]
Comments on this entry are closed.
Or: measure your portfolio value and income in something other than Sterling, this will be rather sobering but gets you away from thinking in a depreciating / appreciating currency. A basket such as IMF SDR’s would be appropriate. C.H.
@All — Cycling Hedgie is referring to Special Drawing Rights (SDR):
http://www.imf.org/external/np/exr/facts/sdr.htm
I take the point, but I don’t really agree that private investors should not be giving some due consideration to their appreciating or depreciating home currency. The vast majority of people live out their lives in one country, bar a few years here and there. If you’re truly a very successful Cycling Hedgie weighing up Montenegro versus Switzerland your mileage may vary. 🙂
Of course you could argue that if they own their own home, have a job and state pension in the UK, and so on, then they maybe should take that into account when deciding whether they have too much overseas exposure.
I must confess I have considered tinkering with my portfolio with Brexit looming. But I just found myself going round in circles trying to guess was all the possible outcomes.
When that happens, I remember that I’m a passive investor and retreat to Option 1 above. Stop looking into my crystal ball and keep on going!
You list a higher TER as a downside, but I don’t think the costs associated with hedging have to be included in the TER. That would make it even more expensive. I am sure I looked at this before, but please correct me if I am wrong.
Well, GBP makes up 8% of the SDR basket anyway. I kind of agree with you, but I don’t think that invalidates the point. We import everything, including labor, so actually your purchasing power in other currencies is what matters, even domestically. The notable (as you did note) exception to this is land, so if you already own a chunk of it then measuring your wealth against the currency basket is reasonable.
If nothing else it avoids the “I’m up 20% this year on my FTSE100 tracker, Brexit is great!” fallacy.
I’m sticking with Lars’s cheap all world portfolio unhedged.
Too many possibilities to know what is going to happen.
I’m happy to ride out any crashes whilst continuing to accumulate, which is likely to beat any “smarter strategies”
At each new FTSE high I’ve been rebalancing an increasing % back into cash and short term bonds rather than trying to guess which way sterlings going to go. My feeling are just about everything seems high at the moment and currency hedging won’t help when the market crashes.
This is of interest to someone close to retirement and wishing to ‘lock in’ some of the recent gains due to the value of the pound falling. I looked on Interactive Investor but couldn’t find any ishares ETFs including the word ‘hedged’. Are they hiding under some other name or where else do you suggest I look for such funds?
@Marco — A very sound approach, as I say. Over a long-term investment horizon the case for currency hedging equities is weak. (Very different for bonds). The caveat is that most countries aren’t going through constitutional crises most of the time. 😉 (i.e. I suspect it’s *a bit* different this time, but we’ll see). I want to back out some of the volatility because I am much more active than the typical reader is (or should be! 🙂 )
@Steve — As suggested in the article, I hunt around on JustETF.
@Thruxie — You seem to be making more a general market call than being concerned about what seems to be our unusually depressed currency. Fair enough, but that’s not what I’m talking about here. 🙂 Good luck with your investing.
@Brendon — I’d be interested in reading sources on that, as that’s not my understanding, though I am far from a world authority on ETFs. As mentioned above I think (/recall?) there may be extra costs associated with the mechanics of the hedging not working optimally, which I am guessing potentially shows up in tracking error. But certainly in the various fund literature I’ve read they don’t point to additional costs arising. It would hardly be there first time they hadn’t, though, so who knows?
These additional costs are clearly much more important if you decide to permanently hedge a portion of your portfolio, rather than tactically hedging for a few years of what seems to be a particularly turbulent UK currency, to reduce risk/volatility. Perma-currency hedging isn’t totally fringe thinking, by the way. I’ve read academic literature and Vanguard making the case for permanent equity hedging on some *portion* of your portfolio.
@all — Here’s an easy-to-browse selection of currency hedged ETFs from iShares. Note the relatively high TERs!
https://www.ishares.com/uk/individual/en/products/etf-product-list#!type=emeaIshares&tab=overview&view=grouped&fac=43511&search=hedged
I’m on the Lars’ side of this and I think that you shouldn’t be seeking for currency hedged etfs unless you think you’ve got an edge. Without the currency hedge, when the pound gets weaker and weaker, you receive more pounds in the dividends and that’s a positive thing, right?
If you are a “keep on keeping on” type then does it come down to a rebalancing issue. Has it triggered a point where a rebalance in necessary back to original allocation. ?
If you never rebalance then keep on keeping on
I must confess although a fan of Lars “just buy VWRL” strategy in principle I’ve sold half of my holding recently as I shift into a more dividend yield based strategy.
Overvalued US stockmarket (about half VWRL is US), low divi yield (sub 2%) and currency risk don’t make VWRL as appealing to me, certainly not for your entire equity holding.
I have bunch of UK and global ETFs and investment trust yielding typically 4-5%. None of them currency hedged though.
For this year and next will be only buying UK assets but again that was already part of my asset allocation plan eveb before the GBP got such a kicking.
Taking any currency fluctuation bonuses and re-balancing into your preset (!) asset allocations should also help reduce losses in the event of a forex correction, which you can then reverse the re-balance to buy up cheaper world equities.
No timing or special feelings in your waters required to make volatility work for you.
I’m trying to be disciplined and am still waiting for my re-balance thresholds to hit.
Brilliant informative thought provoking article !!!
Until now had merely regarded currency changes as just extra volatility to be welcomed for the rebalancing opportunities.
Has set the little grey cells on the go yet again.
Worth pondering.
Thanks for the insight(s).
Interesting article. Any ideas for a Trump hedge?
I’ve thought about selling some of my international funds and buying UK one’s. But as in the article, if I buy the FTSE 100 then it will fall if the £ goes up & buying the FTSE250 could increase volatility if the £ drops again.
So what to do?
I’ve only recently trained myself to stop meddling with my portfolio so I’ve decided upon a mental strategy rather than a market one – i’m still in the accumulation phase so my thinking is that if the £ goes down again, 93% of my portfolio will go up & if the £ goes up then my monthly contributions will buy more each month.
My portfolio is approx 80% VWRL & 20% £ cash in high interest current accounts.
There, sorted! I didn’t need to do a thing.
I have a couple of pension pots with managed funds, which after reading this blog and various books I decided this is madness and I should switch to something like a Vanguard LifeStrategy. The problem I have is that these managed funds are 30-35% UK equity heavy while have only 16% in the US so I’m resistant to taking the hit on selling when the pound is weak but also I want to get out of paying fees on my managed funds (apparently only 1% but who knows what could be hidden/the transaction costs, etc). Like you say, no one can tell which way the pound will go for sure though.
@Andrew – nice portfolio, and I like your thinking
@AP why not buy trackers to reflect the asset allocation you currently have? That way you can just say I’ve saved a bunch of cash on fees and whatever happens to the value of those assets would be (approximately) the same as if you’d done nothing? If pound strengthens then take plunge into LS?
That’s a good thought Rhino, something to think about
I like the the EUXS idea – I have a load of Blackrock continental EU trackers which have received a hefty Brexit boost. I’m tempted to either half split the holding with EUXS or match it with EUXS which would reduce the hangover a bit if the Brexiteers are right and once again the sun never sets on the buccaneering trading empire we are all set to become 😉
@Investor excellent article. Can’t wait for Part 2.
You actually hit my dilemma which was I left cash in the kids JSIPP’s opposed due to the vote and not knowing which way it would go. Now I am so concerned putting it in a world tracker and the pound strengthens, so this actually looks a good option for my kids for a couple of years until we have a grain of an idea of what post-Brexit Britain will look like.
I had no clue these existed so Thank You.
mmm some good ideas here from monevator . Id been unsure/reluctant as to where to invest new money with all the rises everywhere so i quite like the hedged etf ideas.
something to ponder on. thanks.
The investor is something of stuck record – the logic deployed is the currency was fairly valued before the vote and post the vote our economy will be materially worse and hence this justifies the drop, tears are shed – at no point is an argument made for why it was fairly valued before.
If one we to look at UK PLC as a company rather than a country, before the vote, spending more than it earned (expenditure exceeds tax), importing more than it exports and a huge debt growing all the time. If it were a company it would be basket case and the Investor for one would have not have been a buyer and would likely have been selling.
The only reason the currency held up was because it retained a safe haven status, a little of that shine was lost post the vote. But given the emperor had no clothes you have to conclude the currency was due a fall at some point anyway.
The investor clings to this narrative because it supports his political views, which is fine, but for me (and all of you) I suggest divorcing politics from investing it clouds the judgment.
The damage done IMHO to the working man by the inflated value of the pound has been huge. I don’t expect a rapid recovery of competivativenes but equally it was a pretty sure thing to conclude that at previous levels there was no chance it would ever happen.
I remain sanguine, the low pound might cause the Investor some first first world problems, but for the rest it will over time rebalance the economy and give the next generation a better chance they would have had. And I’m in good company the Government and BoE were doing their damndest to get the currency down before the exit vote.
My little grey cells have a finite capacity and it’s not huge. I’ve tried to diversify my share holdings to ensure a decent percentage of overseas income through FTSE shares which are 70% foreign income and through direct holdings of international ETFs and a few foreign shares. The plan was to diversify company , industry, country and, yes, currency in one manageable swoop. The strategy has held up well in the recent pound drop…….. but who knows what will happen in the future. To separately hedge against currency movements seems overkill to someone with my limited ability. I also suspect that virtually nobody can consistently guess currency movements and timing. Furthermore, I have stopped adding to my portfolio so would need to sell large portions to buy a hedged ETF sufficient in itself to have a significant effect on the whole portfolio. I think I’m hedged enough already. Let fate deal it’s hand!
My attempt to eliminate currency risk is to try and hold 50% of my portfolio in stocks denominated in the currency I plan to spend in (£) and 50% in international stocks. Now this does introduce home country bias into the portfolio, so it may water down international gains if the home maket drops while internationally things go up. Plus a large number of the U.K. Stocks will have overseas income so that % will shift somewhat more towards international anyway.
@marked
Your kids aren’t going to be able access their SIPP for maybe 50 years. That’s a lot of time for currency fluctuations to equal themselves out. Probably not worth the extra expense to hedge currency, even for a few years.
@martyn
To be fair, TI’s suggestions are a protection against currency fluctuations caused by any reason, and are not inherently anti-Brexit in of themselves.
Your narrative is as much of a currency play as what you accuse TI of. What proof do you have that the pound was unfairly valued pre-Brexit vote? In Lars words, what is your edge?
Interesting article, thanks, TI.
I’ve always assumed that in currency hedged products I’m paying for the hedge and then I’m paying for their margin on top and so it’s an insurance product — not good for losses you can bear, but to be used for those which you cannot.
Given the windfall, I can afford the risk of a reversal, so I remain unhedged.
Loving headlines about Dow and S&P breaching new (arbitrary) round numbers. Of course that these aren’t £ record highs is never reported but is to be remembered, but rebalancing out of a record high feels somehow grown-up… Farewell sweet VUSA share, you have served me well…
Hi All
Would another ploy be to let your Global Trackers run and rebalance into a Global Bond Fund which is GPB hedged
Vanguard has such a beast -VIGBBD
Might give one the best of both worlds
Equity increases retained in a hedged Bond fund
xxd09
@martyn — If I’m a stuck record, then, given this is about the 15th time you’ve written such a comment, you’re a one-note stuck record. I barely mentioned politics in the article, and I did so in the context of a range of risks.
The pound has fallen sharply because of the Brexit vote, whether justifiably or not, as can be seen on a chart. That’s a fact, not a political opinion.
If Brexit proves to be a great boon for the UK economy, then fears about the current account deficit will eventually dissipate, inward investment will pile in, and the pound will very probably strengthen hard. Moreover if Brexiteers are right that the Euro is a basket case heading towards implosion, it will rise even more strongly. So currency *hedging* (i.e. not all-in bombastic bets) after the moves we’ve seen is arguably appropriate whatever one’s political views.
My investing is influenced by my best guesses, and my acknowledgement that many scenarios are possible. I change my stance all the time, as the facts change; E.g. I noted the UK economy was not hitting the wall that I had expected it would just three months after the vote.
This is what being an active investor is about. To quote Keynes, when the facts change I change my mind.
The possibility of a thriving post-Brexit UK is one of a range of reasons why I’d be uncomfortable sitting with 93% overseas exposure with the pound at multi-decade lows against most currencies after one of the sharpest devaluations of Sterling on record, especially given the devaluation is entirely driven by risk perception so far.
I understand that because you voted Brexit, your insight that global exchange rates have mis-priced the pound for decades is not to be lightly dismissed. I appreciate you’re right about everything, like seemingly the majority of Brexit voters.
Reading my ill-informed drivel must be a trial for you. Feel free to excuse yourself.
If could predict the future i would do the lottery.
I have tried…..didn’t work.
So i diversify, invest (not too large) amounts of money progressively over time, rebalance when there is a significant drift from where i wanted to be. Will it work…no idea. But when experts can’t forecast financial crash, who will win which election, referendum results, price of oil etc …not sure i can do better.
@ Andrew – I like your thinking, and portfolio – which mirrors my own. (Except I’m using iShares equivalents to get dividends automatically reinvested.)
@ All – I wonder if what could also be driving people to think about hedging to protect some of their recent currency gains is simply having too high a proportion of their portfolio allocated to equities given their real risk tolerance? I could myself be in this camp, though I’ve managed to convince myself otherwise. Will let you know if I was right after the next crash…
Interesting discussion. I’m not convinced that much is to be gained by currency hedging, unless you have a specific short term need to crystalise your investments in one particular currency.
for example the FTSE 100 and GBPUSD seem to be inversely correlated at the moment.
@ Richard, etc
re UK weighting
From past discussions here, it seems that there is no single correct answer to the UK weighting question. A good starting point is Lars advice to use global weightings which at present following the sterling fall, think is now somewhere about 7% for UK Stocks.
The following link (if it works) is from the professional body which I think used to be called APCIMS.
It ties in with previous discussions here about overweighting UK for the retiree, etc. But I find the weightings surprising nonetheless, although perhaps in line with Richard’s thinking?
http://www.thewma.co.uk/private-investor-indices/current-asset-allocation/
Personally feel comfortable with anything between 10% to 20% UK Stocks, but have no rational explanation for that comfort zone feeling.
As per the article, it is perhaps timely for us individually to revisit our assumptions?
@RobJ – could you share the acc. type ishare ETFs you are using?
@The Rhino – SWDA & EIMI
@all — Great discussion in the main here. Thanks for the various insights and food for thought!
I’d just quickly chime in on UK allocation / home bias.
When this first became a topic of interest to investors/academics (only 20-30 years ago) it was much harder and more unusual to get easy overseas exposure. Transparent index funds weren’t really in the investing consciousness, certainly not mainstream global ETFs. People made plays on foreign markets like a stock picker might buy say Apple shares today. You ‘got into emerging markets’ because they were hot (or not) and bought a fund accordingly. Few investors had any notion they might even be thinking in terms of global equity exposure.
As a result, US investors say, where from memory the research first arose, typically might have only had 5-10% as I recall in foreign assets.
Now, at least around here, things are very different. 🙂
And that’s great! But I do also feel today that among sophisticated passive investors, there’s a danger that people are going too far the other way. I am not saying that is definitely the case for anyone, or that the ‘Lars method’ of global tracking is wrong, certainly not for everyone.
But the fact is that currency risk is real, has practical consequences, and the more you diversify beyond your home currency the more it’s a factor.
Let’s say I showed you academic evidence that for global investors in aggregate, a global portfolio on average produces the best long-term results at the lowest cost, irrespective of currency risk, over the long run. (Which is broadly what the academic research does say).
You might rightly enough come away saying “global equities for me it is!”
Let’s imagine though that you’re a 65-year old UK retired investor, the long run is 50+ years, and the jolly boost to our portfolios from the weak pound we’ve seen over the past 12 months instead works against you over the next 5-10, cutting your net worth and income by 20%, at a time when you’re reliant on that portfolio for your living and you have no new savings from work etc, perhaps for years to come.
In this case, you might be less inclined to care what worked in the long run for the most people around the world, and more wishing you’d protected what you had over a shorter run.
Let’s say the UK economy balances with a weaker pound, a stronger manufacturing and export sector, a more (supposedly) right-sized financial sector, and so forth. How long does that take? Maybe 10-20 years? How much turbulence along the way?
Is the cheapest, most academically-correct return the best return? Or is making some concessions to the fact that you’re not a global nomad and will be spending UK pounds for the foreseeable future a ‘better’ return?
Currency movements are uncompensated risk, really. It’s not like investing in shares (productive assets that grow an uncertain income over time) or bonds (higher known returns as you take on more risk of default etc). Currencies are a zero sum pairs trade. They nicely diversify your portfolio but they don’t in themselves produce a return.
When you invest in a currency hedged equity ETF, you are to a great extent still getting the diversification benefits, without the currency risk. (I say “to a great extent” because currencies and valuations do have a relationship with each other, and if you take currency out of the equation this might be altered for or against you. But we’re heading into the weeds here…)
I’m also asking these questions rhetorically to some extent. I think we each have to figure this out for ourselves. And again, I’d stress I’m not saying 100% currency hedge your portfolio or anything like that.
I am saying that with the UK pound at multi-decade lows, for whatever reason, where even a modest bounce to a level below where it’s traded since the 1980s would knock off 10-20% of your wealth, then maybe currency hedging *some* portion of your portfolio could prove prudent.
As @magneto recalls, we’ve discussed this a bit before with lifestyling products, where some readers found the increasing home bias towards retirement age off putting. I understand why — I had lunch with Lars this week, and he reminded me why he believes in global trackers etc — but I disagree a bit. I feel currency hedging SOME portion (or overweighting UK equities) is relatively cheap, reduces volatility, and in the real world (not a computer crunching the ‘best’ portfolio) could well be pragmatic and desirable.
Some academics argue currency hedging is prudent ANYWAY, in whatever circumstances. Vanguard for instance has produced research for example arguing the case that you should use currency hedged products to cover some of your overseas exposure — even after explaining why it probably won’t increase your returns and will likely cost more. I’ll discuss this a bit in part two.
To me though, our decision right now as UK investors is more clear cut than in normal times. Because for me these are not normal times. Our currency has dramatically weakened, in short order, hitherto on political risk. It’s not weakened because anything has actually happened yet. The rebalancing that might occur has not even begun!
So for me this is not the normal interplay of currencies and economies — rather the UK economy and currency is “in play”.
To what extent you should respond — to what extent, which may well rightly be “none”, that you feel you want to hedge — could depend on your age, future income, future likely residency, how much you have in (UK denominated) fixed income assets, whether you own your own home and have a mortgage and what share of your total wealth that represents etc. (If you’ve got £300K of housing assets and £10K in shares in a global tracker, feel free to entirely forget about currency risk for now and just keep saving more. You need more currency risk and overseas exposure! 🙂 )
I don’t have the answers to all this, especially not for YOU, but I do think they are pertinent questions. 🙂
Hmm, what strikes me is how every cloud has a silver lining when your in accumulation phase with time on your side. The world is simple and you effectively can do no wrong..
Gets a lot more difficult when you’re decumulating with a dwindling supply of years. You have to consider stuff like this article seriously, potentially laying awake at night over it.
And TI does it for fun not necessity! Not sure I relish the prospect.
@RobJ – that looks pretty good to cover your equities – have you found acc. ETFs for the fixed income part as well?
@the investor. You must be right. I don’t think you need to claim an edge to take your position (which is also mine). It’s more about managing risk. It is no consolation to me that everything will ‘come out in the wash’ over 25 years if I have just had a windfall gain of 15-20% and I am not too far of retirement. What I need to do is reduce the risk of a step increase in the pound. For what it’s worth I do this by taking quite a strong home bias (Lifestrategy plus extra uk trackers) in the first place.
Separately I think the benefits of world diversification while real can be a bit overdone. The markets are all more closely correlated than one would like and crucially when there is a crisis correlations increase (exactly the opposite of what would be best)……
Nice article thanks.
Yes, I did some conversion into GBP-hedged funds several weeks ago. I used IGUS to hedge half of my North American funds and EUXS to hedge half of my Europe funds. I also gbp-hedged half my gold holdings using GBSP. There are also some hedged-GBP versions of OEIC/normal mutual funds accessible to the retail investor which may be of interest to you: There is are GBP-hedged versions of the Legg Mason US Smaller Companies fund, of First State Global Infrastructure and (very useful for afficionados of global equity income funds) of the JP Morgan Global Equity Income fund. There are a lot more gbp-hedged OEIC equity funds (more accurately, gbp-hedged classes of funds) around but these are often restricted to institutional investors. As so often in other areas, the industry has been far too slow to identify and roll out solutions for retail investors.
@Investor . Good article and good points you make. I have usually tried to keep to 50% global 50% UK (bonds ,cash, hedged products etc. can be included in the UK portion). Interesting point you make about the 65 year old investor suffering a possible 20% decline in portfolio value over the next 5 to 10 years if the pound rises in value. I agree with your logic however you could view it as, the 20% portfolio increase being the extra cash you will need to counteract the increase in inflation due to the falling pound. Then if the pound increases in value, falling inflation due to lower import prices would cushion the decrease in portfolio value. I can see higher inflation in the coming years and have converted a lot of my fixed income allocation to inflation linked bonds (XGIG not perfect but good enough). Of course this is only my opinion and could prove wrong.
@The Rhino – I’m afraid not. iShares only has IGLT in its Core series (generally its lower cost options), but dividends are distributed. To be honest I’ve not looked into UK Government bond ETFs that much, as when I originally set my investment strategy it was pre-Brexit and I could get more than the yield IGLT offers (currently 1.9%) with less risk by holding cash in savings/high interest current accounts. However, times have changed, and with inflation picking up (likely turning the real return on even the best paying cash accounts negative) and my portfolio growing this is becoming an issue that I’m starting to give more thought to. But fortunately not a too material one for the moment.
I suppose it depends on what instruments the funds use to hedge the exposure, but…. FX options are a speculative tool rather than a pure “hedging” instrument and hence not cost effective. Hedging an equity portfolio with fx forwards introduces a small fixed income element into the mix via the spread (how much of it, depends on the length of the contracts) and using them in an FI portfolio can kill the yield, which kind of defeats at least some of the purpose of holding international fixed income. With current low rates everywhere it’s not too bad, but if rates begin to diverge significantly the inefficiency can become significant as well. Forward spreads aren’t always linear and the reasons for that are easier to explain in retrospect after it’s normalised (oh, y’know that blip was probably caused by…) rather than at the time when it’s happening, or to predict how long the anomaly would last.
I can see the logic for wanting to reduce volatility when your portfolio is in drawdown, but a weighing towards (domestic) bonds vs equities should take care of that. Personally, I’m not hedging anything. In the long term it’s about the relative strength of the economy, and more than half of the international equity is the US. As the old man Warren B once said, you’re unlikely to get rich by betting against America.
Switzerland is a cautionary tale people quote when they talk about the need for currency hedging, still, in our case, GBP floats freely. SNB messed heavily with CHF in 2012, 13 and 14, which caused the nonsense that followed. And anyway, I doubt the UK is in any danger of becoming the new Switzerland as far as currency markets are concerned. I recon our politics have become way too exciting for anyone to think of the GBP as a safe haven asset for some years.
@ jed – be very wary of inflation linked bonds – there are good articles on this site. In summary the issues are: pension funds / insurance companies forced to buy them / durations are very long / they are priced to lose money under most reasonable scenarios. If interest rates rise their value is likely to fall significantly and they may well not provide the inflation protection you want. They have also enjoyed stellar rises in last few years so just on mean reversion principle there is a risk they will decline.
As suggested, it depends on how long one has before retiring. I’d add that it also depends on the other assets a person has. I’d guess that your average older Monevator reader probably has at least a couple of: 5-10+ years left working (if desired) in a decent job that pays in GBP, at least one house/flat (valued in GBP), at least a decade or so of contributions to a DB pension scheme that will pay out in GBP, a reasonable expectation of receiving the state pension (in GBP), substantial GBP bank deposits and at least a fraction of their self-invested portfolio allocated to gilts. Most of my immediate colleagues (professionals aged 40-65 in a large company) have all of these. Given that, even the older investor probably has a pretty substantial GBP tilt in their net worth and doesn’t need to be too concerned about hedging the international equity component of their portfolio.
Sorry, I’m coming to this article late, but just wanted to say thank you for bringing these ETFs to my attention. I haven’t decided whether to buy some hedged ETFs, but it is helpful to know that there’s a viable way to do so.
I am a complete newbie to this subject. Reading this article a year after publication, is there still advantage in a hedged US etf ? I assume less so. What about Europe ex Uk -I assume no. The other country I am interested in is Japan. Many thanks for original answer and to everyone who has commented and made this so informative
@ Hilary hanes
Hilary, I do not think the US$/£ and Eur/£ decisions are really comparable. The loss in value of the £ versus US$ since the (in my view, bad, Brexit) vote has been much reduced, while the loss in value of the £ versus the Euro is still large. So I think its a toss-up whether to hedge the US funds now but it is not IMHO a toss-up to hedge the European funds. Because I have no sense of what US$/£ might do next, I have gone 50/50 with half my index funds hedged and half unhedged. My Europe ex-UK index stuff is fully hedged.
Did you write the Part 2 for this? Could you let me have the link please
@RobH — Unfortunately I still haven’t written the true part two. I sort of did another Part 1 earlier this year: http://monevator.com/how-hedging-your-shares-against-currency-risk-can-boost-returns/
…but that won’t contain anything new.
Need to pull my finger out! 😉