How to protect your portfolio from currency risk

Sterling remains undervalued

As expected, the Bank of England (BoE) decided to keep interest rates unchanged at 0.5% this week after reports earlier this month of a slowdown in UK economic growth.

The Office for National Statistics (ONS) reported that UK GDP growth fell to a five-year low of just 0.1% in the first quarter of the year, marking the lowest rate of economic expansion since the final quarter of 2012. However, the BoE sees it as a "temporary soft patch" caused by the bad weather, and it expects a rebound in the coming months.

Economists believe the Bank has moved from being more hawkish to "wait and see" stance as it finds itself in the difficult position of having to deal with inflation above its target of 2% and still weak economic growth. Now, an interest rate increase is expected towards the end of the year followed by another in 2019, and a further one in 2020.

Following the BoE announcement, sterling had fallen against the dollar on Friday afternoon, down 0.2% at $1.3522. Sterling had been on a downward trend since the UK's vote to leave the European Union.

On June 23, 2016, the day of the referendum, sterling vs the US dollar was trading at around $1.50, but sold off sharply the following day to $1.32 and as low as $1.20 in January 2017. Currency weakness has contributed to an acceleration in UK inflation, which hit 3% in October last year, prompting the BoE to raise interest rates by 25 basis points from all-time low of 0.25%.

Since then reduced concerns over Brexit, a stronger economy and weaker dollar had sent the currency higher. Despite recovering to date, some analysts still consider the pound to be undervalued and, if an agreement is reached between the UK and EU, it could be back to its pre-Brexit values by the end of the year.

Why the FTSE 100 rises when sterling falls?

Currency fluctuations can have a big impact on market returns. As the market and currency performance table below shows in 2016, the US stockmarket (S&P 500 Index) rose by 12% in US dollar terms, but, mainly due to sterling weakness against the dollar, UK investor would have seen this gain rise to over 33%.

The opposite can also be observed in 2017 when the pound strengthened against the greenback. Then, a 21.8% rise in the US market translated to only 11.3% in sterling terms. In 2013, the Japanese stockmarket (TOPIX index) rose 54.4%, but, due to a strong pound, sterling investors earned less than half of this return – only 24.7%. In 2016, this was reversed, with a very modest 0.3% rise in Japanese equities translating to 23.4% growth for UK investors.

Source: Morningstar Direct    Past performance is not a guide to future performance

The rise and fall in sterling affects earnings and dividend prospects of UK companies and, therefore, could shift share prices. As sterling weakens, UK companies that earn much of their revenue abroad stand to profit from a currency boost when they convert their foreign profits back into sterling, boosting profits, dividends and share prices.

While the FTSE 100 fell sharply after the Brexit vote, it has since staged a strong comeback from under 5,800 to 7,700 today.

Sterling weakness has played a key part in this bounce as companies in the FTSE 100 make 77% of their revenue abroad, so the exchange rate had a considerable impact on their earnings when these are converted back into sterling.

In contrast, the FTSE 250 mid-cap index and FTSE Small Cap are regarded as a more domestically focused, as they include fewer global and more domestic companies that are considered more immune to sterling fluctuations.

Some of our biggest companies in the FTSE 100 pay dividends in US dollars. The latest research, published by Link Asset Services shows the top five dividend paying companies account for 47% of all dividends in the index, with Royal Dutch Shell, AstraZeneca and BP paying dividends in dollars.

In the first quarter of this year, UK dividends fell 0.1% due to a growing exchange rate penalty from a stronger pound. Sterling was 12% higher compared to the first quarter of 2017, which pushed down the sterling value of those US dollar payouts by £879 million.

Should you hedge currency risk?

Many funds available through ISAs and SIPPs have exposure to foreign currencies, which means their returns could be impacted by currency fluctuations, presenting an element of uncertainty for UK investors.

In an unhedged portfolio international stock or bond returns for UK investors could be enhanced when sterling weakens and reduced when the pound strengthens. Some fund managers hedge the currency risk using derivatives, so that any future exchange rate movements between the currency used by the investor and that of the underlying fund holdings do not significantly impact the performance of the fund.

Investors can choose to invest in a fund through a sterling-hedged share class to reduce their currency risk.

As the table below demonstrates, over the last years UK investors benefited from unhedged share classes of funds investing overseas due to weaker sterling against other currencies. However, as the pound started to strengthen, it is clear that investors in hedged share classes should get better returns.

Source: Morningstar Direct          Past performance is not a guide to future performance

Currency impact is very important to investment returns and investors need to consider currency exposure as one of the key elements of their portfolio.

History shows that currencies can be very volatile, and trying to predict their direction could prove a risky strategy for retail investors as no single market can benefit from currency movements in all economic conditions.

It's important to remember the best ways to grow your investments is by investing for the long term in a well-diversified portfolio of different asset classes and geographies to achieve the right mix between risk and return.