I wrote in January 2017 about using currency-hedged ETFs to reduce currency risk in your portfolio.

Back then the UK pound had fallen sharply against other global currencies in just a few short months.

This depreciation had sent the value of overseas funds and shares soaring for UK investors – because overseas holdings denominated in dollars, euros, or yen were now worth much more in sterling terms.

Everyone likes volatility when it sends things up. 2016 was a banner year for globally diversified UK investors. Currency risk turbo-charged our portfolios.

But currencies are fickle. After such a steep and politics-related move, I felt the risk of the pound reversing represented a vulnerability to my net worth. So I chose to reduce currency risk in my overseas equity exposure by switching some of my money into hedged ETFs.

Now, the standard advice for long-term investors is to hedge bonds but not equities.

But to paraphrase myself:

Imagine you’re a 65-year old UK retired investor, the long-term is 50 years (which you haven’t got) and the boost to our portfolios from the weak pound we’ve seen over the past 12 months turns to work against you over the next 5-10 years.

Imagine a pound rally cuts your net worth and income by say 20%, at a time when you’re reliant on that portfolio for your living and you have no new savings – perhaps for years to come.

After a 20% fall in your income, you might be less inclined to care what worked in the long run for the most people around the world.

You might rather wish you’d protected what you had over a shorter time frame.

Academics can dine out on long-term results in their research papers. But in the real world we need to eat our portfolios some day.

A tale of two trackers

As it happens, we haven’t had to wait a decade to see what happens when the pound starts to climb out of its hole.

Sterling rose against the dollar in 2017. This rise reversed some of the windfall gains that UK investors in US assets enjoyed the previous year – but the very strong US stock market returns of 2017 easily papered over these currency losses.

Take a look at the total return of two ETFs tracking the US market in 2017:

• The iShares Core S&P 500 ETF (Ticker: CSP1)
• The iShares S&P 500 GBP Hedged ETF (Ticker: IGUS)

Source: JustETF

According to Morningstar:

• The hedged ETF returned 19.8%
• The unhedged ETF delivered 10.8%

Choosing the hedged ETF enabled you to enjoy most of the gains of the US market last year. With the standard ETF, you lost some gains due to the stronger pound.

What a drag!

We can see that currency hedged ETFs enable you to take currency risk out of your portfolio. Over some periods, like last year, they also boost your returns.

Of course, there are drawbacks.

Most obviously – swings and roundabouts!

In 2016 currency risk increased your returns when the pound fell. In 2017 it was a headwind that it paid to hedge against. What goes around comes around. You might have a simpler life just letting currencies do their thing and not trying to be too clever.

But there are more concrete concerns.

The hedged iShares S&P 500 ETF is more expensive. It has an ongoing charge of 0.20% compared to 0.07% for the vanilla version.

Even worse, as I wrote last time this figure may not represent the true cost of hedging.

Such ‘hidden costs’ are likely to show up in tracking error, which is the difference between the fund return and the return of the index it follows.

The S&P 500 returned more than 21% in 2017 with dividends reinvested1 – much more than the hedged S&P 500 ETF. So it does seem like the hedged ETF leaked a chunk of returns. This could be due to the cost and/or the implementation of hedging.

Of course you wouldn’t have complained last year, because by opting for the hedged ETF you still enjoyed much higher returns anyway.

But if you held the hedged ETF for many years, the impact of such a drag would add up.

Hedging your bets

This tracking error arguably underlines how hedging currency risk with equities is only something to do over the short to medium-term, if you want to maximize your long-term returns.

Remember – even small differences will compound into big differences over time.

But not all investors want or need to maximise their returns.

As you get older, you should typically take less risk because you have fewer years to make up for mishaps. In retirement you might well consider lower returns to be a price worth paying for greater stability and less risk to your spending money.

Or you might still be young, but just want to sleep better at night!

So as always, there’s going to be some personal decisions involved.

Please see my previous article on currency hedged ETFs for more on their pros and cons. I also discussed other ways to reduce currency risk, such as deliberately owning more UK shares than the 7% weighting in a typical world tracker fund.

Also look out for my follow-up post. This will explain why the case for currency hedging is different with bonds compared to shares.

1. See Benchmark returns on THIS iShares page [↩]

What caught my eye this week.

I had hoped 2018 would see a return to a more regular content schedule on Monevator. But a family funeral put paid to that.

Sitting in the crematorium, I was struck as ever how money didn’t get a look in during the service. The readings talk about an active family life, the arc of a career, a few funny anecdotes and perhaps a sad one. There’s nothing about financial legacies, let alone more mundane money matters.

I’d like to know whether even Warren Buffett’s memorial service will mention his beating the market? I doubt it will dwell.

This is a very trite observation. There’s plenty of other everyday life essentials that get short thrift at funerals. Who wants to talk about money at such a time? (In my experience only undertakers, but that’s another matter.)

And I do think money sneaks in around the edges of the story. When a parent is praised for providing for a family or giving the kids a good start, that’s partly code for earning and spending on them (and much more, of course.)

Equally, someone may enjoy a fruitful career, but few can do it for the anecdotes alone. Show me the money, as they say.

I usually go away from these events pondering whether I’m too obsessed with saving and investing money. I know money can’t buy love. What would I do with it if I knew exactly when I was going to die?

Outside of their jobs, their mortgage, a company pension, and the usual cash savings, I don’t know that either of my parents spent any time thinking about money. It certainly didn’t guide their life decisions. The financial lessons I got from my father were about frugality, not compound interest or P/E ratios.

Money was managed, but it wasn’t actively multiplied. That was a very different mindset from some of the parents I later met through friends and girlfriends.

I don’t know where the balance is.

Investing and all the rest comes naturally to me. I don’t feel like a scrooge when I pursue my active investing – I imagine I feel the same enjoyment my uncle did when he was doing something in the greenhouse listening to Test Match Special.

What’s more I don’t get the impression most of my friends and family who care less about money are spending their time writing poetry or planting oak trees or visiting aged relatives. (Often they’re just spending!)

And yet…I wonder.

Excuse the maudlin note, though I feel it doesn’t hurt to ponder these things now and then. Feel free to share any thoughts on how you weigh up spending your time and money now – versus shepherding it for the future – in the comments below.

Have a great weekend!

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What caught my eye this week.

Investors can be overwhelmed by 2018 forecasts in the first week of January. Those with long memories might ponder how much use such punditry was in 2017. Or in any of the years before that.

As an alternative to trying to guess the future – or to making your future self into a better you, via a raft of resolutions – how about getting to know who you really are now?

Most people tend to think they know themselves best. And the sort of personality types that are drawn to investing and financial freedom – INTJs, in the lingo discussed by My Deliberate Life in the links below – often feel those who are different are not different but wrong.

In reality, we’re all driven by different impulses, for good as well as ill. Those motivations can be a mystery to ourselves.

Which is all a long-winded way of introducing a cute quiz from Schroders called InvestIQ:

My results from the quiz reminded me that I am an individual thinker who does deep research – and also that I’m a natural pessimist. It also claimed I’m much more anxious about investing than the average person.

I was surprised by this last point.

My first thought was anxiety is an edge as (for my sins) an active investor!

My second thought was no wonder my stock picking adventures have become increasingly stress-inducing over the past few years.

Something to ponder in the weeks ahead, anyway.

Take the test and see how you fare.

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