The challenge with currency hedging

While the US dollar was continually getting stronger and sterling was continually getting weaker, British investors rarely needed to worry too much about currency movements. If you held an international fund that was benchmarked to the MSCI World or a similar index, your currency exposure was around 60%-70% to the US dollar and the trend worked in your favour.

If the era of the strong dollar is over – and the Trump administration’s policies imply that it probably is – that will no longer work in our favour.

Even if the US stockmarket keeps going up – which is quite possible if the US Federal Reserve cuts rates aggressively – a weaker dollar would mean much lower gains for foreign investors.

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One obvious conclusion is that investors will give much more thought to whether they should hedge currency exposure – eg, by buying currency hedged classes of exchange traded funds (ETFs).

For example, an ETF such as iShares Core S&P 500 is available both as a share class that is quoted in sterling (LSE: CSP1) and one that is hedged into sterling (LSE: GSPX). The first will be affected by how the dollar moves against sterling. The latter will be hedged against it to some extent – but there will be a limit to this as well.

How currency hedged funds work

To understand why even a currency hedged fund won’t insulate us from currency movements completely over the long term, it’s useful to think about how funds hedge currency exposure.

Hedging means using forward contracts to lock in the exchange rate at which the investor will buy or sell a certain amount of the currency on a future date.

Of course, the exchange rate that is locked in will not be the same as today’s exchange rate. For every currency pair such as the sterling and the dollar, there will be a forward rate for a transaction in one month, one year, five years and so on. The forward price should depend on the difference in expected interest rates over that time period. If it did not, an investor could earn risk-free profits by borrowing in one currency; investing the proceeds at a fixed interest rate in a different currency for one month; and buying a forward contract to exchange the second currency back into the first currency (and repay the money borrowed) without taking any risk of how exchange rates will change.

If you have very certain long-term cash flows – eg, from an infrastructure project – you can enter into very exact hedges. You buy forwards to perfectly match the foreign currency you expect to receive when you receive it. This is not true for most equity or bond ETFs or funds, where future returns may be uncertain and where money may flow in and out of your fund all the time. So a currency hedged fund typically enters into a series of short-term forwards, which it continually rolls over. This certainly helps smooth out currency volatility – but in a world in which interest-rate expectations and hence forward exchange rates become more volatile, it may not always work as well as investors expect.

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