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Is currency hedging right for you?

Graham Smith

Graham Smith - Market Commentator

Hedge funds have endured a bad press over recent weeks, lately becoming embroiled in political wrangles over Brexit as well as the final days of Thomas Cook. Accusations – the present stock in trade of Westminster – have been hurled at various funds suspected of setting themselves up to profit from a further fall in the value of the pound in the event of a no-deal Brexit or helping to drive UK companies to the precipice.

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Such allegations help to perpetuate the thesis that hedge funds feed on the failures of others to achieve short term profits. Yet, in the vast majority of cases, this would be entirely untrue. Hedge funds generally seek to smooth out the returns they provide investors or offer alternative strategies to help investors complement their existing fund portfolios, and who could argue with that?

These aims are often achieved through the kinds of investments we are most familiar with – conventional positions in shares, bonds or currencies – coupled with less familiar “short” positions in similar types of assets.

Short positions can be achieved simply by reversing the order in which assets are bought and sold. By selling first then buying back later, an investor can profit from a falling price, in a reverse of what happens when a conventional “buy first, sell later” transaction takes place.

For most individual investors, the hedge fund world is on the cusp of what is realistically accessible. Many hedge funds are designed for professional investors, who are deemed better able to weigh up the risks involved, and have minimum investment thresholds that exceed the means of ordinary investors. Liquidity – which determines the ability a fund has to meet daily repurchases – can also be an issue.

However, increasingly hedge funds are now being offered to retail investors – Franklin Templeton is the latest example of a mainstream provider making a limited range of offshore, liquid hedge funds available to individuals¹.

Some more conventional funds already call upon similar strategies to hedge funds in order to reduce their reliance on stock market conditions. The Invesco Global Targeted Returns Fund and Jupiter Absolute Return Fund both now feature on Fidelity’s Select 50 list of favourite funds and both employ strategies that hedge fund investors would immediately recognise.

More commonly, the option open to investors is whether or not to shield their investments from movements in currency markets. Some funds investing in foreign shares – principally offshore funds as opposed to those domiciled and regulated in the UK – offer share classes designed to filter out some or all of their foreign exchange exposure, leaving investors exposed only to the fortunes of the underlying companies they invest in.

That could prove useful to sterling investors if, say, Britain unexpectedly leaves the European Union with a favourable deal. In that case, the pound might be expected to rally from its current depressed levels. However, a stronger pound would tend to reduce the value in sterling of investments denominated in overseas currencies.

A recurring theme is the attraction or otherwise of hedging investments in Japan. Historically, the Japanese government has favoured policies that promote a weak yen. While this policy risks keeping fundamentally uncompetitive companies afloat, it is generally seen as a good thing for the country’s legions of vehicle, electronics and machinery exporters.

Even so, while a weak yen may tend to lift the value of Japanese shares in local currency terms, these improvements are prone to being erased for foreign investors; who have historically sometimes seen the overall value of their investments being eaten into by a corresponding rise in their own currencies in relation to the yen.

This will not have proven a restriction over the recent past for sterling investors in Japanese funds. Sterling has lost about 11% against the yen over the past year². However, once again, a fresh impetus to sterling could quite easily see this situation move into reverse. 

It’s still the case, however, that currency hedges are most common among bond rather than equity funds in the UK, limiting the options available to most investors. The Fidelity Strategic Bond Fund and Jupiter Strategic Bond Fund – both Select 50 funds – hedge their global investments back into pounds.

It’s worth remembering too that hedging entails costs. Currency hedged funds continually renew or “roll over” financial derivatives contracts that protect against currency movements. The ongoing fees this process incurs have to be paid out of a fund’s investment returns.

The cost of hedging could vary significantly over time according to market perceptions about the risk of a currency falling. Earlier this year, overseas investors in US government bonds were reportedly abandoning US dollar hedges because they had become too expensive to maintain³.

Another point worth remembering is that when the currency of a target country rises, investors in a hedged fund miss out on the uplift. In short, there’s no telling over any reasonable period of time whether any foreign currency losses that might occur will be more or less costly than the expense of hedging.

That may prove no barrier for some investors with specific strategies in particular markets. However, hedging may be of limited benefit to others who can, in any case, largely diversify away the risk of adverse movements in individual currencies through a broadly diversified, global investment strategy.

The Fidelity Select 50 Balanced Fund is an unhedged case in point. It provides a broad markets and currency exposure by investing in 30 or so other funds, mostly taken from Fidelity’s Select 50 list.

Alongside the UK and Europe, accounting for around 22% and 27% of the fund’s assets currently, are the US (30%) Asia (6%) Japan (9%) and smaller positions in Latin America, Africa/the Middle East and Australasia. That ought to be enough to ensure there is no overreliance on any particular currency scenario coming to pass and interrupting a path to long term investment returns.

Source:
¹ Citywire, 01.10.19
² Bloomberg, 01.10.19
³ FT, 18.04.19

Important information The value of investments and the income from them can go down as well as up, so you may get back less than you invest. Overseas investments will be affected by movements in currency exchange rates. There is a risk that the issuers of bonds may not be able to repay the money they have borrowed or make interest payments. When interest rates rise, bonds may fall in value. Rising interest rates may cause the value of your investment to fall. Select 50 is not a personal recommendation to buy or sell a fund. This information is not a personal recommendation for any particular investment. If you are unsure about the suitability of an investment you should speak to an authorised financial adviser.

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