The currency hedging conundrum

British savers have benefited from diversifying their investments away from UK shores in the quest for lower risk and better returns.

Those who have held US equities for the past five years – rather than the FTSE – have enjoyed returns that are 40 per cent better in local currency terms, but 80 per cent better in sterling terms, due to the weakness of the pound versus the strength of the US dollar.

If you also held some other international stocks, it’s likely that you would have scooped up better returns with lower volatility than by just investing in the UK market – particularly as the foreign exchange (FX) exposure would have acted as a very effective stabiliser when the pound plummeted after the Brexit vote.

However, increasingly hawkish comments from Bank of England governor Mark Carney and other members of the Monetary Policy Committee have delivered something of a jolt to those clever (or just lucky) enough to have plenty of FX risk in their portfolios.

Remember, 52 per cent voted for Brexit, but far fewer actually believed it would happen – including Nigel Farage – hence sterling touched $1.50 on the eve of the vote.

So, here we are now at $1.32, having hit $1.20 in January, and life is getting much trickier for people who have lots of foreign investment.

Binary predictions

Sterling does look incontrovertibly cheap on lots of long term measures, even though Brexit has the potential to move the goalposts definitively.

Sterling positioning is currently neutral, following the Carney-induced short squeeze.

The problem is that predictions around the currency all feel a bit binary, based on some very unpredictable political scenarios and outcomes, including Brexit negotiations, Tory indiscipline, and the limits of voter incredulity surrounding the scope of Corbynomics.

So, while it seems obvious that UK investors should hedge at least some of their foreign currency, actually doing it is difficult in practice for private investors.

Some equity and bond funds – and exchange-traded funds (ETFs) – offer GBP-hedged share classes, but they aren’t always available. And, in the case of ETFs, hedged versions generally cost a lot more.

Eroding fees

In the immediate post-crisis years, hedging costs were minimal and easily ignored.

But now, investors have to stomach a headwind of around 1.5 per cent each year to hedge US dollars back into pounds. In this ongoing ultra-low-yield world, this more than offsets anything you might gain by investing in a higher yielding US Treasury, rather than an equivalent gilt.

The problem is, if you don’t hedge the currency, the FX volatility will likely overwhelm the expected total return from the bond. This FX volatility looks set to stay with us, and it swamps the potential returns from already expensive equities and bonds.

Hedge your bets

Currencies are clearly relative value bets. The numerous drivers of the US dollar, euro and Japanese yen matter just as much as any sterling-specific forces, and the unwind of quantitative easing will undoubtedly cause palpitations in those currency markets.

Hedging may be costly and sometimes difficult to execute, but it would be rash not to neutralise some of the currency risk.

If you have a globally diversified portfolio, it’s likely that currency risk currently dominates everything else.

For some, it might be an intentional bet, but it seems a high stakes coin toss to me. And the investment graveyard is strewn with the corpses of those who fancied themselves as good at calling currency markets.