Currency – to hedge or not to hedge?

Investing internationally brings a wealth of different sectors, diversification potential and growth opportunities to a portfolio. In theory, it should help investors to generate improved returns, with lower risk than if they confined themselves to their home market. However, it may also bring additional risks that need to be managed – and the most pressing of all is currency.

Foreign exchange risk can affect an investor’s returns in a number of ways, for good or bad. If a European company generates significant revenue in the US, for example, it will benefit from a strong dollar, which boosts the value of that income in euro terms.

It is perhaps most evident when investing in non-European markets, when returns can be significantly influenced by exchange rates. If the euro is higher against the US dollar or other international currencies, it reduces the return from investing internationally; a higher dollar increases it.

The impact can be significant. The MSCI World Index delivered a gross annualised return of 8.84% over the 10 years to the end of September 2023 in US dollar terms, compared with 10.96% for the index denominated in euros, because of the appreciation of the dollar over the decade.

Currency factors can be particularly important when investing in emerging markets.

Volatile emerging market currencies

Currency factors can be particularly important when investing in emerging markets. The currencies of countries whose capital markets are less developed tend to be more volatile and can be significantly affected by relatively small levels of capital inflows and outflows.

Over the past three years, for example, Mexico’s peso has appreciated strongly against the euro, which bought 19.26 pesos as of October 6, 2023, compared with 27.29 on March 20, 2020. This has been extremely good news for European investors in Mexican assets, including financial securities, over the period, irrespective of their performance in domestic currency terms. By contrast, South Africa’s rand has slipped from 16 per euro to 21 since April 2022, reducing the return of investment for Europeans.

Sometimes, currency weakness reflects sentiment towards a particular country. This means investors can face a downturn in the stock market and weakness in the currency, magnifying their losses, or an appreciation in both, boosting their returns.

Should you manage it?

The decision to hedge currency risk for long-term investments should be based on an individual investor’s specific situation and investment goals. As always when it comes to investment, it’s essential to weigh the potential benefits against the costs and risks.

It may not always be easy to disentangle currency risks. For example, a company might receive its revenue in US dollars, prompting an investor to consider hedging dollar risk. However, companies routinely hedge significant currency assets and liabilities, which makes it difficult to judge the real impact of future currency fluctuations.

At the same time, fund managers may selectively employ hedging to manage their exposure to assets not denominated in their base currency. Disaggregating this to understand how much risk should be hedged and whether this needs to change over time is often difficult and may bring little benefit.

Frequently, the right time for hedging is when you don’t realise you need it.

It should also be remembered that hedging can be expensive – and can get more costly just at the wrong time. Hedging dollar risk, for example, becomes more expensive as the US currency appreciates. However, if the dollar has already risen substantially, that may not be the right point at which to hedge – frequently, the right time is when you don’t realise you need it. Currency markets are volatile and unpredictable: it would take an uncannily smart investor to recognise the need for hedging in advance.

When hedging makes sense

In general, it will make sense to use hedging where there is a specific liability in one currency and income in another. This might be where an individual has a residential property loan in one currency, but receives the income used to reimburse the loan in another.

It may also make sense to hedge in the case of an event where the outcome is unclear, but where the impact could be significant – a dramatic example being the UK’s referendum on withdrawal from the European Union.

It may also make sense to hedge in the case of an event where the outcome is unclear, but where the impact could be significant – a dramatic example being the UK’s referendum on withdrawal from the European Union. There may also be considerable currency volatility surrounding elections or critical economic policy developments.

Another case where hedging may be justified is if you have substantial exposure to a particular region that is not your home market. If you have invested heavily in the US technology sector, for example, this will probably entail significant exposure to the dollar. If technology companies fall in value, the dollar may weaken. Hedging can provide some diversification and reduce the concentration of your portfolio.

Hedging techniques and instruments

It can be relatively easy to hedge when placing money in investment funds. In many cases, funds looking to attract investors from different countries will have currency-hedged and unhedged versions. A hedged version of a fund can give investors exposure to companies from a particular country or region without also taking a risk on its currency.

Investors can also use currency exchange-traded funds, which provide a vast range of options, particularly for the world’s major currencies. It is possible to buy a long or short currency ETF if you have a strong conviction about a currency’s future direction. It is also possible to trade directly in currency, but this involves significantly more risk and should not be attempted without experience or expert advice.

The most straightforward way to hedge currency risk is by using forward contracts. Agreeing to buy or sell an agreed amount of foreign currency at a predetermined rate at a specified future date enables an investor or business to lock in an exchange rate, providing certainty about its future direction and effectively neutralising the impact of currency fluctuations on a particular transaction.

It is important to calculate the cost of hedging carefully. Hedging is liable to act as a drag on your returns, especially if you pay too much.

Anticipating the highs and lows of volatile currencies is complex, and, in the end, may not add a great deal of value to a portfolio.

Anticipating the highs and lows of volatile currencies is complex, but fluctuations could jeopardise an investment portfolio’s return. Hedging currency risk will reduce short-term volatility, which might make the investment journey smoother. It will certainly provide greater predictability in the cash flows of the underlying investment (if any) and reduce uncertainty.

But hedging isn’t free – there are costs involved in implementing and maintaining hedges. Some will argue that the impact of currency fluctuations washes out over the long term, making hedging unnecessary. But one should remember the famous quote of John Maynard Keynes: “In the long run, we are all dead.” Waiting for that long-term equilibrium could mean considerable pain in the meantime.