Global investing and currency hedging: Performance and impact
There are a whole host of factors that come into play when investing in a global selection of assets. Often disregarded, a key element of global investing is currency exposure, and with that, the associated exchange rate risk.
Over the long term, currency hedging can provide you with valuable protection and returns, particularly in volatile markets. However, against the market backdrop of 2018 which saw significant sterling volatility, currency hedging had a negative impact.
Here we outline some of the key considerations for UK investors exposed to global equities and explain how currency hedging can impact or benefit a global, multi-asset portfolio.
Global equity investing: Currency exposure is an automatic by-product
You don’t just have to think about currency and exchange rates when travelling abroad, it applies to investing, too. To put it simply, if you’re a UK investor with any stocks or bonds in your portfolio from outside of the UK, you are automatically exposed to the currency of those countries.
Take for instance the MSCI World Index, which is only made up of 6% UK equities.1 The rest is comprised of equities from outside the UK such as the U.S., Europe and other countries. An investor in this index therefore, doesn’t just have equity holdings – they also have direct exposure to the other countries’ currencies such as dollar, euro and yen. In other words, this currency exposure is an automatic ‘by-product’ of a global equity investment.
Currency exposure and exchange rate risk
You wouldn’t want only 8% of your salary to be paid in sterling, and the rest in dollars, euros and yen etc. – would you? So why accept your investment income like this?
Ideally, it needs to be converted into your home currency. Therefore, a global equity investor is subject to an additional layer of risk: the risk of loss when these other currencies are exchanged for their equivalent in sterling, i.e. exchange rate risk.
In order to manage this exchange rate risk, the currency exposure can be hedged using forward exchange contracts.
Currencies move up and down: Use Purchasing Power Parity as a value anchor
Like most asset classes, currencies go through prolonged return cycles, moving up and down over time. Purchasing Power Parity (PPP) is used to compare different currencies and is a value anchor for their moving prices. It works by calculating the exchange rate at which a basket of goods cost the same in two different countries by accounting for differences such as inflation rates and cost of living.
In this chart we have mapped the standard market exchange rate for GBP/USD (black line) against the Purchasing Power Parity exchange rate (orange line) since 1994. As you can see, it is not rare for the market exchange rate to deviate 20/30% above or below the Purchasing Power Parity exchange rate (blue and red lines). When the exchange rate is very expensive or cheap like this, there is a tendency for it to eventually return back to the Purchasing Power Parity rate which is considered fair value or ‘normal’.
Chart 1: GBP/USD market rate regularly deviates from PPP, but eventually mean-reverts
Source: Thompson Reuters Datastream as at 11, February 2019.
Brexit and the depreciation of sterling: Performance implications
Over the second half of 2018, sterling depreciated significantly, falling well below its Purchasing Power Parity exchange rate. Since 1994, this has only happened once before – following the Brexit referendum on the 23rd of June 2016. We attribute this fall in the price of sterling then, and in 2018, to the political uncertainty surrounding Brexit.
As a result of this depreciation, sterling hedged equities suffered negative returns over 2018 due to the continued fluctuations and depreciations in sterling. As you can see in the table below, unhedged global equities benefitted from their currency exposures and were able to participate in the upside, losing less overall.
MSCI World total returns 1 January – 31 December 2018
|Sterling-hedged global equities||-8.4%|
|Unhedged global equities||-2.6%|
Source: Bloomberg as at 8, February 2019.
Sterling volatility looks set to continue in the face of ongoing uncertainty surrounding Brexit negotiations and the run up to the 29th of March. And this may see sterling-hedged assets continue to suffer versus their unhedged peers. For example, sterling started 2019 on the up and has appreciated against all G10 currencies (as 27th February 2019).
However, we believe that over a longer-term perspective, the price of sterling will stabilise once the future relationship between the UK and the European Union becomes clearer.
As in the chart above, past experience suggests that sterling is likely to appreciate and return to fair value, or to a more ‘normal’ price.
2019 and beyond
Last year was a worse-case scenario for sterling-hedged assets and markets as a whole. Against this backdrop, the only asset class that performed well was foreign currency – an extremely rare market event.
It is important to remember that there are multiple drivers of currencies such as monetary policy, geopolitics and market sentiment, making direction impossible to predict. Investors would do well to consider how this can impact the performance of a global portfolio over the longer term, when reviewing their investments.
1 As at the 12th February 2019.
Any opinion expressed is that of Russell Investments, is not a statement of fact, is subject to change and does not constitute investment advice.