The effect of exchange rate changes on sterling investments

Whether or not financial advisers were panicking over the imminent disappearance of Marmite from their breakfast tables – a threat now thankfully lifted – most will be pondering the effect of falls in sterling on investors’ overseas assets. All things being equal, a falling pound will mean the value of overseas assets rises in sterling terms – a $5,000 investment that was worth £3,521 when the exchange rate was $1.42 is now worth £4,099 at a rate of $1.22.

The currency volatility seen since the European Union referendum is unusual, but far from unprecedented; in any case, even relatively small exchange rate changes can have a significant effect on the sterling value of investments, particularly for someone with a portfolio of international assets, given the number of moving parts in their holdings.

This is certainly an issue for the large global investment companies that have become so popular with investors and their advisers as professionally-managed one-stop shops for international stock market exposure. Many of these funds have enjoyed a boost from the fall in the pound since the vote in favour of Brexit in June; equally, they’re vulnerable to a potential sterling recovery.

Investors in such funds therefore need to take currency risk into account. They’re not only taking a view on the prospects for global stock markets, but also on currency market movements – exchange rate volatility may be sufficient to wipe out the underlying investment return achieved by the fund, positively or negatively, or it might soup up the return.

So how much currency risk do global investment companies expose you to? The answer to that question depends on two factors: the overseas exposure of the fund in question and whether or not it engages in currency hedging in order to try to negate foreign exchange volatility.

Look at the research conducted by the Association of Investment Companies in the run-up to the referendum and you’ll see that it isn’t possible to generalise about these funds – their exposure to overseas markets varies considerably, as does their attitude to hedging.

So, for example, Independent Investment Trust actually holds 93 per cent of its assets in the UK, and is therefore much less exposed to exchange rate movements than, say, Henderson International Income, which has nothing in the UK, or Scottish Mortgage and Monks, which both have less than 10 per cent of their assets here. Bear in mind too that the picture will be complicated by funds that have investments in other funds, which may be UK-listed but with their own overseas exposures.

Once you’ve identified the overseas exposures of individual funds, you also need to look into their policies on currency hedging – they may choose to do that via the derivatives market, through their gearing policies (by borrowing in overseas currency, say), or even by trading on the currency markets.

In practice, the AIC’s research found, while most global investment companies have a mandate from their boards to hedge against currency risk where they see fit, only a minority tend to put this into practice. Many funds take the view that the cost of currency hedging does not justify the benefits, particularly since, over time, exchange rate movements may balance out.

Advisers, however, need to decide whether they feel comfortable with that approach to hedging. It may be that after investigating the exposures of a particular fund, you’re happy with the question of currency risk. But the experience of recent months underlines why this isn’t a risk that should ever be ignored.