When investing overseas, currency movements can add an extra layer of risk as exchange rates move. Kenneth Lamont explains how ETF investors can ride out currency risk.
When you invest in – for example – an S&P 500 ETF, you are tracking the movements of the US large-cap equity market, but you are also left at the mercy of the USD/GBP exchange rate.
This is not a trivial point. Since the Brexit vote in 2016, the pound has dropped 15% against the US dollar, boosting already strong US equity returns to UK-based investors.
In this case, the currency played in favour of UK-based investors, but this is not always the case. For example, between June 2012 and August 2015 the MSCI Japan index (a proxy for the Japanese stockmarket) soared by 75%. Over the same period, the Japanese yen fell by almost 50% against the pound, crippling returns to a UK-based sterling investor.
There is a ‘theoretically correct’ long-run price for any two currencies, which is found when the buying power of each is the same in both of the two home countries. In reality, academic ideals and reality rarely match. Currency movements are driven by a diverse range of factors, including market sentiment and all sorts of central bank and government policy actions such as interest rates, quantitative easing programmes and currency pegs.
Therefore, currency movements are very difficult, if not impossible, to predict. Many investors are happy to ride out the currency risk, but for others it can be a genuine source of concern. Thankfully, ETF providers now offer well over 100 currency-hedged options for UK-based investors, which offer protection from this unwanted risk. These funds mitigate (rather than fully eliminate) the currency risks, leaving fund returns tied closely to those of the underlying markets.
Brexit currency risk
As a UK investor, your unhedged foreign investments have likely benefited from currency devaluation since Brexit, but now remain vulnerable to a sterling recovery.
The following are stand-out core equity ETFs which can be used to protect your portfolio against a strengthening pound.
The GBP-hedged Xtrackers S&P 500 ETF (XDPG), with an ongoing charge of just 0.09% is one of the cheapest and most efficient ways to tap a market which is a core building block in most investors’ portfolios.
For those with an eye across the Channel, the iShares MSCI EMU GBP Hedged Distributing ETF (CEUG) – with an ongoing charge of only 0.12% - is a useful tool to access the eurozone while keeping the currency risk in check.
Hedged options are not limited to single currency exposures. For example, the Xtrackers MSCI World GBP Hedged ETF (XDWG) offers global equity exposure protected against the movements of a global basket of currencies for a competitive ongoing charge of 0.29%.
Due to their less volatile nature, currency fluctuations often play an even bigger role in the returns of fixed-income holdings. The Vanguard Global Aggregate Bond ETF GBP Hedged ETF (VAGS) offers low-cost currency-shielded exposure to global investment grade bonds for a low fee.
Meanwhile, the iShares JP Morgan $ Emerging Markets Bond GBP Hedged Dist ETF (EMHG) offers currency-protected exposure to the benchmark of reference for emerging market debt.
Cost of hedging currency
Unfortunately, hedging currency movements comes at a cost. While management fees are clearly visible, other charges, such as the cost of maintaining the hedge are less easily identified. Ultimately, however, both costs showup in how closely the ETF tracks its index.
The flipside of protecting against losses is that hedging will also lock you out of any currency gains too. In our original Japanese example, the option of buying a currency-hedged MSCI Japan ETF would have been extremely profitable, as between June 2012 and August 2015 the iShares MSCI Japan GBP Hedged ETF produced a return of 101.9%. In contrast, the unhedged US dollar version of the same ETF returned just 12.9%.
But, hedging does not always pay off. For example, being locked into a hedged S&P 500 ETF post-Brexit would have resulted in significantly lower returns. The performance gap between the two types (a hedged ETF and a non-hedged ETF) is around 33% from the start of July 2016 to the start of July 2019.
Ultimately, the decision to hedge can save your portfolio from unwanted fluctuations in currencies, but it must be understood that it won’t always play in your favour.
GBP-hedged ETFs listed on the London Stock Exchange
|Name||Ticker||Global category||Fund size (millions GBP)||Ongoing Charge (%)|
|iShares JP Morgan $ EM Bd ETF GBP H Dist||EMHG||Emerging Markets Fixed Income||7,764||0.50|
|iShares MSCI EMU ETF GBP H Dist||CEUG||Europe Equity Large Cap||1,972||0.12|
|Vanguard Global Aggt Bd ETF GBP H Acc||VAGS||Global Fixed Income||211||0.10|
|X MSCI World ETF 2D GBP H||XDWG||Global Equity Large Cap||3,958||0.29|
|X S&P 500 ETF 2C - GBP Hedged||XDPG||US Equity Large Cap Blend||929||0.09|
Source: Morningstar, July 2019
Kenneth Lamont is analyst of passive strategies, manager research, at Morningstar.