Note: Exchange rates between different currencies fluctuate all the time, and the currency pairs used below are purely illustrative from the time of writing. Today’s numbers aren’t relevant to understanding currency risk.
One area where investors and even experts get themselves into a muddle is currency risk – specifically when it comes to the currency that a fund is priced or denominated in.
Currency risk [1] itself is pretty straightforward. It will be familiar to anyone who has ever been on holiday or who owns a property abroad.
Let’s say you’re a British resident who’s headed to the U.S. for a vacation in three months. You decide to take some dollars with you, and you opt to convert a whopping £1,000 into dollars because you’ve heard you’ll need to tip big to avoid a riot.
You’re also very old-fashioned, so you want to get this sorted out three months in advance.
Ignoring transaction costs1 [2] and at the time of writing in 2013:
- At a rate of £1:$1.60, your £1,000 buys you $1,600 dollars
Let’s suppose that before your holiday, the pound strengthens so that £1 now buys $2. But you’ve already changed your money, at the old rubbish rate!
- At the new rate of £1:$2, your $1,600 is now worth (1,600/2) = £800
Ouch!
It could have gone the other way, too, of course.
Currency risk has upside as much as downside.
Currency risk and the underlying assets
Converting holiday money is straightforward – and exactly the same thing happens when you make overseas investments [3].
Let’s say that rather than going on holiday, you do what I’d do – being a tightwad [4] – and invested £1,000 into a tracker fund that follows the US market instead.
All the stocks in the tracker fund are based in the US, listed on the US markets, and priced in dollars as you’d expect. Your US tracker fund is therefore buying a bunch of US dollar denominated assets.
At a £1:$1.60 exchange rate:
- Your £1,000 investment buys $1,600 of dollar assets2 [5]
Three months later, the exchange rate is £1:$2. If the US stock market has not changed over the period, you’d log on to your broker and see:
- Your investment is now worth $1,600/2 = £800
Of course it’s more likely the market would also have moved over three months, as well as the exchange rate. If the US market had gone up 10%, your investment would be worth £880. If it had fallen 10%, you’d be looking at a princely £720.
In fact, it’s usually stock market moves not currency moves that will dominate your returns.
(Also, currency fluctuations usually – though not always [6] – happen more slowly than in my example, which I dialed to ‘high’ to make my point.)
Fund denominations don’t matter
Safari, so-goody, as Christopher Biggins used to say in a kid’s TV program that has me showing my age.
Where people get confused is when they buy a fund that is denominated in a currency other than that of the underlying investment.
A typical example would be a UK-traded ETF that tracks the Japanese market, but is denominated (/priced) in euros.
The mistake people make is they think they are exposed to multiple currency risks – in this case the euro as well as the Japanese yen.
This is wrong – you are only exposed to the underlying asset’s currency.
Lots of people make this slip. For example, when I wrote this article Morningstar had an article up (since removed) about fund denominations that stated:
…unless, of course, you really know what you’re doing when it comes to forex and, for example, you want to take a bet that emerging market currencies will appreciate against the euro, that the euro will appreciate against sterling, and that these events will converge in time for when you choose to sell your shares.
The implication of this quote is that a UK investor who buys an emerging market fund that’s denominated in euros faces a double-whammy of two currency risks – the pound versus the euro, as well as versus the emerging market currencies.
That’s incorrect.
As a UK investor you’re only exposed to emerging market currency risk in buying the euro-denominated fund. The exchange rate between the pound and the euro is irrelevant.
Currency risk: The science bit
I’ll show why it’s the underlying asset currency that matters in two different ways.
First I’ll use a bit of algebra, and then we’ll go through a real-life example.
Algebra first.
Let’s say you are a UK investor who has rather oddly decided to buy a euro-denominated ETF that holds only UK shares.3 [7]
The Euro-priced ETF holds UK-listed assets – BP, Tesco, Lloyds, and so on – that are denominated in sterling.
(1) The quoted price of the ETF in euros:
= Value of UK holdings * (pound/euro exchange rate)
Now let’s say you log into your UK fund platform to find out what your ETF investment is worth today in pounds – your native currency.
Clearly its £ value is equal to the value of the ETF in euros, adjusted for the euro/pound exchange rate.
(2) In other words, the value of the ETF in £:
= Price of ETF in euros * (Euro/pound exchange rate)
Now we can substitute (1) into equation (2) to give us the value in pounds as:
= Price of ETF in euros * (Euro/pound rate)
= (1) * (Euro/pound rate)
= (Value of UK holdings * (Pound/euro rate)) * (Euro/Pound rate)
= Value of UK holdings * (Exchange rates cancel out)4 [8]
= Value of UK holdings
In other words, as a UK investor who is investing pounds, this fund of UK assets is worth its value in pounds, regardless of whether it’s priced / denominated in euros, yen, or Malaysian ringgits.
What about if you were a UK investor buying a euro-priced ETF that invested in the Japanese stock market?
Here the underlying assets are Japanese, so the exchange rate that matters for a UK investor is the pound/yen exchange rate.
To see this, we can modify my equation above to take the value of the ETF in pounds to be:
= Value of Japanese holdings * (Pound/euro rate) * (Euro/Yen rate)
= Value of Japanese holdings * (Pound/Yen rate)
Again, the pricing currency (here it’s euros) is irrelevant and vanishes from the equation. The euro introduces no extra currency risk.
Note: Some funds hold a lot of cash, which may introduce an additional currency risk. If for example you own a European-based investment trust that invests in Japanese equities but that holds 10% of its assets as cash in euros, then as a UK investor you do face currency risk on those euros, as well as on the much larger exposure to the Japanese yen. Cash held by ETFs and trackers is usual trivial, however, and can be disregarded.
Currency risk in the real-world
Let’s really drive the point home with a real-world worked example.
Imagine the Japanese tracking ETF mentioned above comes in two denominations – the original euro-denominated ETF that we looked at above, and another one denominated in pounds sterling.
As a UK investor, you’d be naturally drawn to the ETF denominated in pounds. But in theory it makes no difference which one you buy5 [9].
Let’s look at the pound denominated Japanese tracking ETF first, using real data from Google Finance for historical stock market levels and exchange rates.
It’s 6 Jan 2012 and you decide to invest £1,000 into this Japan-tracking ETF.
At the time of your investment:
The Japanese stock market is at 8,390
£1 buys 119.5 yen6 [10]
You invest £1,000, which means you invested in yen terms:
1,000*119.5 = 119,500 yen
On 4 January 2013 you decide to cash out. Over that time the Japanese stock market rose to 10,688 – a gain of 27.4%.
So your investment in local yen terms is:
= 119,500 yen plus the 27.4% gain
= 152,243 yen
We now have to convert back into pounds. Turning again to Google Finance, I see that on 4 January 2013:
£1 buys 141.6 yen
So your investment is worth in pounds:
= 152,243 / 141.6
= £1,075
Notice that although the local market went up 27.4%, you’ve only gained 7.5% in pounds. That’s because the pound strengthened against the yen, which meant your yen bought fewer pounds when converted back into sterling. This is true currency risk in action.
Hopefully that was pretty easy to follow. But what if you’d bought the euro-denominated ETF?
Trickier to work out, as we need to know a couple more exchange rates.
On 6 January 2012:
One pound bought 1.21 euros
One euro bought 98.6 yen
So – deep breath! – you again invest £1,000:
£1,000 = 1,210 euros
1,210 euros = 119,472 yen
As we saw, the Japanese market rose 27.4% over the year.
This time your investment in local terms:
= 119,472 yen plus a 27.4% gain
= 152,208 yen
Checking on Google Finance, I see on 4 January 2013:
One pound bought 1.23 euros
One euro bought 115.2 yen
So converting back:
152,208 yen = 1,321 euros
1,321 euros = £1,075
Magic! Again you have ended up with £1,075, despite the fact you invested via a euro-denominated ETF.
The exchange rate changes between the pound and the euro have disappeared from the equations. It is the exchange rate between your currency and the currency of the investment – in this case the yen – that matters, and determines your currency risk.
Why this happens: Related currency pairs are perfectly inter-connected, which is what enables the denominating currency to ‘disappear’ above. If this wasn’t the case, then you could profit when currency exchange rates got out of kilter. For example, you might be able to convert pounds into yen, and then convert those yen into euros, and then convert those euros back into your original currency, pounds, for a profit. You can’t do this because the currency markets are extremely liquid [11], deep, and efficient, and any miniscule opportunities like this are immediately arbitraged away.
Currency risks and rewards
Don’t be surprised if you see people saying something different to the above. They’re wrong and I’m right, as the worked example I plodded through above proves, even if you weren’t convinced by my elegant algebra.
Check the figures with Google Finance if you don’t believe me! And see this similar example [12] that uses the Thai baht.
The takeaway should be clear:
- Currency risk is determined by the local currency of your foreign asset.
- Even if you buy a vehicle that is priced in your own currency, such as a UK investor buying a UK-listed ETF that’s denominated in pounds, if the fund invests in overseas stocks then you’re exposed to the currency risk of the underlying assets.
Despite the scary name, currency risk isn’t necessarily a bad thing, as you can win as well as lose. Also it’s another kind of diversification and so in some ways it can reduce risk [13].
With that said, there’s a strong argument that you’re not really being compensated with higher returns when you take on currency risk and so you should avoid it where you can.
This is a huge topic for another day. Broadly speaking, currency risk is less of a concern when investing in overseas stock markets but something you’d ideally avoid when investing in overseas government bonds. (For much more detail, see this long paper [14] by Vanguard).
You can avoid currency risk in any asset class by using the appropriate currency-hedged [15] ETFs. This may increase your costs, however.
You definitely need to think about your home currency when allocating for the long-term. If you’re going to be a UK pensioner, it would be madness to have all your assets in Japan. One day you’ll need to spend pounds in the shops and you don’t want to be completely at the mercy of the prevailing pound/yen exchange rate when you retire.
Most UK pensioners would have a large stock of UK government bonds, however, or perhaps an annuity or other sterling-based asset. And of course putting all your money in Japan is the antithesis of passive investing as we explain it around here, which is based on global diversification [16].
As a product of a well-constructed long-term portfolio [17], currency risk is not something to be afraid of.
- The costs of exchanging money at airport booths and so on are massive in the real world, and you should explore all the different ways to pay abroad, such as the newer Fintech solutions – but that’s another article. [↩ [22]]
- Again ignoring any transaction costs. [↩ [23]]
- An ETF targeted at European investors, in other words. [↩ [24]]
- One small caveat is there may be money changing charges made by the fund or charged by your broker when converting from one currency to another racked up along the way. But that is a separate issue. [↩ [25]]
- As throughout this article I’m ignoring small currency related transaction costs that are a different issue [↩ [26]]
- I am going to ignore small rounding errors throughout for clarity. [↩ [27]]