Investors with overseas fund holdings need to be aware that even a slight movement in currency rates can have a significant influence on fund performance and present a risk that must be considered.

It is also important to note in which circumstances fund managers ‘hedge’ or neutralise currency exposure in order to understand how a fund works.

Rob Morgan, pension and investments analyst at Charles Stanley Direct, explains:

“The usual situation, when purchasing a global equity fund for instance, is that foreign currency exposure is ‘unhedged’, which means the manager takes no steps to nullify or mitigate the impact of currency fluctuations. To give a very simplistic example, if a holding denominated, say, in US dollars rises by 3% and on the same day the US dollar falls 1% against the pound, the return to the fund is 2%.

“Had the currency been fully hedged the return would have been 3% minus the cost of paying for the hedge. As a UK investor buying overseas investments, you actually want sterling to get weaker (i.e. £1 buys less foreign currency) after you have made your investment as the overseas holding will be worth more.

“Turning to bond funds, aside from funds in the Global Bond sector, which generally expose investors to the currencies in which the underlying holdings are denominated, foreign exchange exposure is almost completely hedged. The sector rules dictate that funds in the Corporate Bond, Strategic Bond and High Yield sectors have at least 80% of their portfolios in sterling assets or hedged back to sterling.

“This makes sense as bonds are generally less volatile than equities so currency movements have a greater impact proportionally on returns. Additionally, many investors use bond funds to produce a steady income, and would prefer this not to fluctuate as a result of foreign exchange movements. Those that have a bearish long term view on the pound, however, might wish to consider funds in the global bond sector that are not hedged. Where it applies, currency hedging is typically achieved by buying derivatives contracts that move in the opposite direction to the currencies the fund holds.

“However, even with equity funds currency risk can sometimes be far greater than the volatility of the underlying assets, a particular case in point being Japanese funds in the past year. The yen’s sharp fall has highlighted the argument for UK investors using sterling hedged funds over non-hedged counterparts. The Japanese government has pursued a policy of pushing the currency down in a bid to help the country’s exporters and boost its economy. The stock market has soared as a result, but those gains have been significantly diluted for non-hedged investors due to the weakening yen.

“In recent years a number of fund groups have made sterling hedged versions of their popular Japanese funds available, thus enabling investors to receive a return close to that of the market, without the foreign exchange risk.

“However, in most cases equity investors will probably not wish to choose hedged funds, reasoning currency is part of the aggregate exposure they want. Currency effects will often wash out of fund performance over the long term through the relative performance of the local market.

“In addition, the foreign exchange markets are notoriously difficult to predict and running a hedge adds to the fund’s costs. Where funds hedge “opportunistically” or “tactically” it is important to consider whether this has added value or reduced risk appropriately.”