How to protect your shares portfolio from currency risk

What is currency risk?

Investing in shares listed on an international exchange involves swapping your home currency for the currency the overseas stock is denominated in. For example, if I buy shares in Amazon, I will swap GBP for USD in order to buy the shares.

When the time comes to sell my shares, the exchange rate may have changed, which means that for the period I hold Amazon stock, I am at the mercy of the GBP/USD exchange rate.

At the time of writing, you can exchange £1 for around $1.31. As an example, here’s how a change in the exchange rate will impact investment returns for UK investors holding US shares.

1. USD strengthens versus GBP = increases US share returns
2. USD weakens versus GBP = decreases US share returns

It is important to remember that currencies do not provide investors with a coupon or yield. In other words, they have no intrinsic value. Over the long term, then, currency exposure does not add to investment returns. Currency risk does, however, increase your portfolio’s volatility.

How does currency risk impact investment returns?

The price of a nation’s currency reflects the outlook for its economy, inflation, interest rates, and government policy compared to that of other countries. Over multiple economic cycles, currency fluctuations tend to cancel out, meaning that over the longer-term currency exposure has a limited impact on your investment returns. This can be shown by looking at the average annual change in the GBP/USD exchange rate over different time frames:

The figure above shows that over the longer term currency fluctuations have a more muted impact on the value of your portfolio.

Put differently, over a shorter time frame, changes in the exchange rate can add to or detract from investments returns considerably. The table below shows the minimum and maximum average annual currency returns over different time frames:

^{Source: IG}

For instance, the largest increase in the GBP/USD exchange rate over a one year period was between February 1985-1986; where the GBP strengthened against the USD to $1.492 from $1.0545, or by +41.8%. Over this period, the S&P 500 saw total returns of 30.1%, but UK investors faced a 8% loss due to the stronger GBP and weaker USD.

If you are planning to invest in foreign shares for one month, six months or a year; exchange rates should form an important part of your investment thesis. That said, predicting currency markets is difficult at best.

Over the previous decade, UK investors have indeed benefited from a strengthening US dollar. But the impact of currency fluctuations can go both ways. In 2016, the S&P 500 index returned 9.5%, but a UK investor earned close to a mega 31% due to a strengthening USD. The next year, things went the other way, with the S&P 500 index rising by over 19%, but UK investors only seeing returns of 9%.

The table below shows the price returns for the S&P 500 index in USD and GBP terms over the last decade:

Without stating the obvious, the difference in returns for individual US shares would have been of the same magnitude.

Hedge currency risk using a spread bet or CFD

Hedging currency risk may sound complicated, but in reality it is relatively simple. Investors can use a derivative contract such as a spread bet or a CFD contract to reduce the effect of unfavourable exchange rate movements.

To hedge out currency risk when buying international shares, you need to sell the currency in which the shares are denominated in and buy your domestic currency. If you need to buy GBP and sell USD, you would buy contracts in the GBP/USD currency pair.

For example, if you had £10,000.00 to invest and decided to buy shares in Apple, at an GBP/USD exchange rate of 1.30562, you would end up with $13,056.20 worth of Apple stock.¹

Assuming the same GBP/USD exchange rate, $1.30562 can be exchanged for £1. In this case, GBP is your base currency and USD is the quote currency. In line with the example above, it would cost you $13,056.20 to buy £10,000.00.

You could do this by buying one CFD contract in GBP/USD. As a general rule, one CFD contract is worth 10,000 of the base currency.

If you had bought £50,000 of Apple shares, you would simply buy 5 CFD contracts in GBP/USD to hedge out your currency risk.

Investors can choose to use a spot contract or a forward contract. If you are planning to hold your position for more than a few weeks it can be cheaper to use a forward contract. This is because you do not pay an overnight funding fee on forward contracts.

But unlike spot FX contracts, which stay open for as long as you wish to hold the position, forward contracts have an expiry date. At the end of each period, you can choose to automatically roll your exposure into the next forward contract to maintain your position.

Learn more about hedging with spread bets and CFDs

Using exchange traded funds to hedge currency risk

There are two ways to use exchange traded funds (ETFs) to hedge currency risk. Investors can either buy an exchange traded currency or an equity ETF with an in-built currency hedge.

Exchange traded currency (ETC)

ETCs are financial products that provide investors with exposure to currencies that track the value of a currency or a basket of currencies. These can be used to speculate on a currency pair as well as hedging currency risk.

WisdomTree is an ETF company which specialises in currency ETFs. The largest ETCs listed on the London Stock Exchange (LSE) by fund assets are shown in the table below:²

Investors can buy these using IG’s share dealing service in an ISA, SIPP or general investment account.

Currency-hedged ETF

One way a UK investors can invest in an international stock index but automatically eliminate the currency exposure is by investing in a currency hedged equity ETF.

One real life example is to look at an ETF which has an in-built currency hedge versus its non-hedged equivalent. For the analysis below we have used iShares S&P 500 UCITS ETF and iShares S&P 500 GBP Hedged UCITS ETF:

You will notice from this chart, along with the table above, that UK investors holding US shares benefited massively in 2016, the year the UK voted to leave the European Union. This was because the GBP weakened considerably against the USD, meaning that proceeds from selling US shares would have been converted into GBP at a more favourable exchange rate.

On the flipside, when the currency your international shares are based in weakens versus your home currency, your investment returns will be reduced.

Please note that the two ETFs used in the example above are used because they have a longer track record than newer, cheaper alternatives that iShares now offer. CSP1 offers exposure to the S&P 500 without any currency hedge at an annual cost of 0.07%, which GSPX has an in-built GBP hedge at an annual cost of 0.10%.

Costs and benefits of hedging international equities

The cost of hedging foreign exchange exposure and the risks associated with its execution should be weighed against its benefits.

Benefits of currency hedging

• Removes the uncertainty when investing in international assets.
• Reduces your portfolio’s volatility.

Costs of currency hedging

• As with all investments, there are costs involved in trading or investing in the financial instruments described above.
• For spread bets and CFDs, there are spread costs and overnight funding costs to consider.
• For ETFs, there is a fund fee which can be found in the ETFs KID document.

Risks of currency hedging

• Predicting the direction of a currency is notoriously difficult. As shown in currency fluctuations table above, hedging can be beneficial or detrimental to investment returns.

Learn more about hedging with us:

• A beginners’ guide to hedging strategies
• How to avoid market risk
• How to hedge your shares portfolio in a downturn
• How to hedge forex positions
• How to hedge risk in crypto markets

Footnotes

¹Not factoring in costs and fees.
²Excludes leveraged currency ETFs.