We look to cut the confusion and explain different currency topics and the effect currency may have on investment performance.
Currency can be a rather confusing topic and it can apply to various different aspects when it comes to investing. We recently saw the Great British Pound (GBP) fall to its lowest against the US Dollar (USD). Does this mean the GBP isn’t so ‘great’ anymore and what effect does this have on your investments? As long-term investors, it’s important to understand how currency may affect our investments. In this article, we will cut the confusion and explain different currency topics, the effect currency may have on investment performance and finally, our approach.
There are many different topics surrounding the confusing world of currency. Let’s discuss the most important currency topics for investors when investing in funds and ETFs.
One of the main currency considerations is called the base currency. This quite simply is the currency a fund reports its performance in. This doesn’t necessarily have anything to do with what the fund is invested in but there is often a link. For example, you could have a European stock market fund where the base currency is in Euros (EUR), but you could also have the same fund in a different share class currency such as USD where the base currency is in EUR. It is important to know that the investor is not exposed to the base currency, and it will not impact the performance of investments.
Trading currency is probably the most familiar amongst investors as it is the currency used when buying and selling funds. Funds and ETFs can have different trading currencies. For example, ETFs can be traded in GBP, USD and EUR. We live in a globalised world where we have the ability to invest overseas, exposing our investments to other currencies. As a result, investments are exposed to risk currency which is the currency exposure to the underlying investments of a fund. For example, the global stock market is formed of over 60% US companies and around 3% in UK companies. If you were to invest in the global stock market in GBP, you would be exposed to a higher percent of currency risk as opposed to an investor investing in USD. In this example, a GBP investor is exposed to the GBP/USD exchange rate as a result.
Currency hedging can be seen as a way to mitigate currency risks of an investment portfolio. This is a strategy which investment managers may use to reduce the exposure to foreign currency swings and volatility. This method can work both in favour but don’t forget it can also go against. The main consideration for investment managers hedge currency is for risk rather than return.
Currency Risks And Investment Performance
We have identified the main currency topics investors may consider but how do currency fluctuations impact performance? Over the short term, currency fluctuations may have an effect on investment performance as we recently experienced with the decreasing value of the GBP against the USD. However, over the longer term a very different story emerges.
The chart above shows GBP vs USD/EUR/CHF/AUD compared with the performance of the global bond market over the long term. Currency valuations are dwarfed by the performance of the global bond market which is seen as a less volatile asset class showing that currency volatility really is much of a muchness.
Now, the chart above shows GBP vs USD/EUR/CHF/AUD, but this time compared with the global stock market which we see as a driver of returns. The chart indicates that the currency volatility really is insignificant and over the long term will have little to no effect on investment performance. This is very much in line with what many economists believe, such that currencies will reach equilibrium over time, known as the purchasing power parity between countries.
As an attempt to reduce currency risks on investment performance, investors may choose to invest in home country specific funds. However, this can actually have an adverse effect and increase risks to the portfolio. Investing in home country specific funds still have multiple risk currencies as companies within the portfolio will receive a large portion of their earnings abroad. It’s important to understand that currency exposure does not equal the local currency of any given stock market. For example, investing in the US stock market does not mean 100% USD exposure. Therefore, by investing in one country, you are limiting diversification and increasing risks associated with home country bias. To put this into perspective, if a UK investor only wanted to invest in the UK stock market, they would be limiting diversification as the UK only makes up around 3% of the global stock market.
At Skybound, we are long term investors, and so pay little to no attention to currency fluctuations on the equity side of our portfolios. We believe that the long-term performance potential of the stock market, as our main driver of investment returns, outweighs any possible impacts currency may have and will always put investment performance first.
As for bonds and alternatives their main role is to reduce volatility and we want to give them the best possible chance to do so. By removing currency volatility through currency hedging or sticking to local currency bonds for example, it allows this part of the portfolio to do to its job to the best of its ability. Currency can get confusing as there are many aspects and topics. At Skybound we have qualified financial advisers and investment professionals on hand to clarify the currency confusion for you in detail. For more information, visit our website and request a call back today.