The trouble with hedging the currency risk on your overseas investments

Here at MoneyWeek, we encourage readers to avoid falling prey to "home bias" the tendency to be far more heavily invested in your own country's stockmarket than is justified by its global clout. This affects investors in all countries, and the risk is that it leaves you over-exposed to one geography and under-exposed to great opportunities elsewhere. For example, the UK has few tech stocks if you want those, you need exposure to the US or China (see page 24).

However, investing overseas introduces another layer of risk currency risk (see box). If you buy assets in a foreign currency, then any gains or losses in the underlying asset can be distorted by changes in the relative value of the pound. So many funds both passive and active offer "currency-hedged" options. These promise to strip out currency fluctuations and thus deliver the underlying return made on the assets you've invested in, undistorted by sterling's ups and downs. So the question is: should you do it?

In a word, no. At least, that's what a look at the data suggests to the Financial Times. I examined returns on hedged and unhedged versions of various overseas funds. Over the past five years, the unhedged funds have largely beaten their hedged counterparts in markets as diverse as Europe, Japan, the US and emerging markets in some cases, with a performance gap of over 20%.

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Case closed? Not really. The recent past is a poor comparison period. Sterling collapsed after the Brexit vote. That instantly meant that the value of any non-sterling-denominated assets shot higher in sterling terms. With the pound now unlikely to repeat that collapse, the next five years could look very different.

We'd argue that you should largely avoid hedging, but not because of recent performance. The real issue is cost. Hedging makes a fund more expensive to run. As we all know, costs are the one thing we can control as investors, so we want to keep them as low as possible. So the question is: why would you invest in a hedged fund rather than the cheaper unhedged version? The reality is that you are taking a view on the currency either way. Broadly speaking, if you knew that sterling was set to weaken against a foreign currency, then you would want unhedged exposure. If you thought it was going to strengthen, you'd hedge.

But you don't know what the exchange rate will do either way. So unless you have a very high-conviction view on sterling (which may of course be wrong), then why buy the more costly version of a fund? If you like a market, get the cheapest exposure that you can, hold for the long run, and leave currency trading to the gamblers.

I wish I knew what currency risk was, but I'm too embarrassed to ask

Currency risk (or exchange-rate risk), as applied to investment, is the extra layer of risk you take by owning an asset in a foreign currency. Say you are a UK-based investor and you buy an S&P 500 tracker, which is denominated in US dollars. The US stockmarket stays flat, but the pound falls in value against the dollar. As a result, your S&P 500 holding would gain value in sterling terms, even though the market has stayed flat. In the same situation, if the dollar had weakened against the pound, then your holding would have lost value in sterling terms.

So, currency risk represents a further factor that can affect your returns, either positively or negatively. One way to try to tackle currency risk is by hedging. Put simply, this involves using derivatives to neutralise movements in exchange rates, leaving the investor exposed only to the underlying asset class.

However, this is not a cut-and-dried decision, as we discuss above. One factor to consider is that exposure to foreign currencies can be a useful feature of global portfolio diversification, rather than an irritating side-effect.As the slide in sterling after the Brexit vote demonstrated, owning overseas assets when your home currency is on the way down is a nice way to diversify away geopolitical risk.

Also, remember that most major stockmarkets contain many multinationals, all of which are exposed to currency risk. For example, almost half the revenues generated by S&P 500 companies come from outside the US and the figure is more than two-thirds for the FTSE 100. So even if you invest solely in Britain's "headline" index, you are still taking currency risk it's just not as obvious.

Finally, as Tim du Toit of Quant-Investing.com points out, if you do decide to hedge, do it consistently. If you chop and change, you are effectively betting on currency movements and that's a recipe for disaster.