This is not only bad news for holidaymakers, but also for investors. Currency movements can have an important impact on investment returns.

Currency is a consideration for all UK-based investors in overseas markets. In theory if sterling is high against the Dollar or Euro, it is cheaper to buy US or European assets. This applies as much to stock markets as it does to the local wine. Equally, it is bad news for those with existing holdings of overseas assets, who would see a drag from the currency were they to sell.

In many collective investments, the fund manager will hedge the currency risk, so sterling-based investors are not exposed.  This means that they use foreign exchange contracts, known as swaps, to offset potential losses or gains that may be incurred by the currency risk

In bond funds, for example, most fund managers hedge the currency risk when investing in bonds denominated in currency other than sterling. The IMA classifications will often state the amount that must be in sterling-based investments: For a bond fund to qualify as a constituent of the Sterling Corporate Bond or Sterling Strategic Bond sector, it must invest at least 80% of its assets in sterling denominated (or hedged back to sterling) securities.

With regard to share-based funds, most investors will use the sterling share class. In this sense, there is no immediate risk. However, for those managers that run funds investing in overseas markets there could be a risk. Many do not hedge the currency risk. They tend to cite one or all of these three reasons:

Firstly, the underlying earnings of companies tend to include overseas earnings, and therefore accurately hedging currency risk is impossible. It is also argued that the impact of currency will be reflected in the underlying earnings of the company. The latter point may indeed be the case, but the impact in earnings may not, necessarily, be reflected in a change in share price.

Secondly, over a longer period of time, the impact of currency movements ‘washes through’ as currency parings alternate from highs to lows. This, however, neglects fundamental shifts in currency pairings or specific action by a central bank to weaken the country’s currency. The most recent example of this would be the quantitative easing (QE) undertaken by the Bank of Japan in order to try and weaken the Japanese Yen. Over the last 12 months the Yen has depreciated against Sterling from ¥153.14 to ¥170.57, representing a fall of circa 11%.

Thirdly, fund managers are skilled at stock selection and are not currency experts, and therefore do not wish to add currency management to their skillset. Although the currency market is one of the most fluid and liquid markets in the world, they argue, it is also one of the most volatile.

So, how has currency impacted returns generated from investing in overseas equity markets? The table below highlights the returns generated in local currency and sterling terms from well-known regional equity indices.

The conclusion should be that investors need to know the currency risks they are taking. If they are long-term holders and can wait for currency to work out over time, then they need not worry as much, but anyone else may want to consider a fund that employs hedging.  

US: S&P 500

Local Currency (US dollar)

Year to date – 4.07%
1 year – 17.96%
3 years – 43.00%
5 years – 109.28%

Sterling

Year to date – 2.76%
1 year – 6.62%
3 years – 40.32%
5 years – 101.19%

Improvement/worsening investing from sterling

Year to date – -1.31%
1 year – -11.34%
3 years – -2.68%
5 years – -8.09%

Europe: DJ Estoxx 50

Local Currency (euro)

Year to date – 4.99%
1 year – 18.38%
3 years – 13.63%
5 years – 32.47%

Sterling

Year to date – 2.67%
1 year – 12.66%
3 years – 5.84%
5 years – 22.77%

Improvement/worsening investing from sterling

Year to date – -2.32%
1 year – -5.72%
3 years – -7.79%
5 years – -9.70%

Japan: Nikkei 225

Local Currency (yen)

Year to date – -10.18%
1 year – 6.23%
3 years – 50.95%
5 years – 53.66%

Sterling

Year to date – -8.65%
1 year – -4.71%
3 years – 18.27%
5 years – 38.59%

Improvement/worsening investing from sterling

Year to date – 1.53%
1 year – -10.94%
3 years – -32.68%
5 years – -15.07%

(Source: FE Analytics, all price performance to to 31 May ’14)

From the above figures we can see that currency has had a negative impact on the returns generated by UK based investors over all time periods shown bar one. This is due to the strength which we have witnessed in sterling as the UK continues with its economic recovery.

This negative impact from currency will not always be the case, unless sterling was to permanently appreciate against the foreign currencies shown. There are a few funds that offer either a currency hedged class or can strategically hedge currency exposure in the fund, but these are few and far between.

Nor would we advocate investors hedging currency positions themselves. There is a cost to the hedge and cash must also be maintained within the fund should there be a cash delivery required at the point a currency hedge is rolled forward. Most importantly, could the direction of a currency pairing be accurately predicted? Probably not.

We conclude that the currency risk taken when investing sterling in overseas equity funds is something that will simply have to be accepted. However, be aware that when it is reported that an overseas equity index has risen by a particular percentage, this may not be the return which you as an investor have gained, even as a passive investor. Be careful on which currency basis the return quoted has been based on.

Selecting overseas equity funds that are diversified in terms of country exposure should help mitigate the impact of currency on returns. Where currency impact is most significant is when currencies are volatile as they are subject to large foreign inflows or outflows, economies have diverged, or where the currency is being deliberately manipulated, like most recently in Japan. As ever, diversification of your portfolio is important to ensure that you are hedging your bets too!

Paul Milburn is investment analyst at Lowes Financial Management