Does this fund currency trick boost returns?
28th September 2022 10:57
by Kyle Caldwell from interactive investor
Kyle Caldwell explains how fund investors can mitigate currency risk through buying a special share class.
Most people don’t think much about exchange rates until they are about to holiday overseas, or on those rare occasions when it becomes front-page news, which happened earlier this week when the pound hit its lowest level against the US dollar.
However, there are sound reasons why investors should pay closer attention to exchange rates. Certain shares benefit when a currency falls – FTSE 100 firms in the case of the slumping pound – due to them deriving most of their earnings overseas. Such companies see their exports become considerably more competitive by weaker sterling, which boosts their earnings.
- Find out about: Free regular investing | Interactive investor Offers | ii Super 60 Investments
UK income investors are also beneficiaries of the weak pound. More than two-fifths of UK dividends are paid in euros and dollars, and exchanging them for a weakened pound has the effect of boosting dividends for UK investors.
On the other hand, mid and small-cap companies with a greater domestic footprint, which are housed in the FTSE 250 and FTSE Smaller Companies indices, are negatively impacted by a weaker pound as this results in higher input costs.
As far as fund investors are concerned, the weak pound has been a blessing rather than a curse so far in 2022. US and global funds have been the main beneficiaries from the fact that assets priced in dollars are now worth more in pounds. This has benefited funds that own US stocks, including global funds, which tend to have 50% to 75% of their portfolios devoted to the region.
While the S&P 500 index is, in dollar terms, down 22% year-to-date, the average US fund has declined by just 5.2%. Therefore, anyone who has held an unhedged position in the US will have benefited from the strong dollar and weak pound.
- How a weak pound and strong US dollar impacts fund investors
- Kwasi Kwarteng’s explosive mini-budget 2022: winners and losers
- Sterling hits record low: the bond and stock market winners and losers
However, while the effect of this has been positive so far in 2022, there will be times when the reverse is true.
For fund investors wanting to mitigate currency risk, some overseas funds come in special versions that strip out changes in the exchange rate. These versions, called “hedged share classes”, have identical holdings and the same fund manager. The difference is the currency hedging means that British investors will see the same percentage rise in their funds as local investors, with no reduction or benefit from currency swings.
Such funds are not trying to call the market, the hedge simply aims to cut out currency exposure, good or bad.
Bear in mind, though, that hedging costs money, so annual charges on hedged share classes are typically 0.1 to 0.2 percentage points higher.
Analysis by interactive investor of five funds that have hedged and unhedged share classes shows how much a difference currency swings can make. Most striking is that over one year the unhedged share class of JPM US Equity Income is up 20.2% versus a loss of 4.1% for the hedged share class.
However, while in the past year UK investors with exposure to US shares have benefited from unhedged share classes, over one, three and five years, it has paid off to strip out Japanese currency exposure. The hedged share classes of Jupiter Japan Income, Lindsell Train Japanese Equity and Schroder Tokyo, show higher returns versus the unhedged share classes.
- The funds set to benefit from Liz Truss’ spending splurge
- Six ways the falling pound could hit your finances
Dzmitry Lipski, head of funds research at interactive investor, points out that investors need to consider currency exposure as one of the key elements of their portfolio.
However, he cautions that: “History shows that currencies can be very volatile, and trying to predict their direction could prove a risky strategy for retail investors as no single market can benefit from currency movements in all economic conditions.
“It’s important to remember the best way to grow your investments is by investing for the long term in a well-diversified portfolio of different asset classes and geographies to achieve the right mix of risk and return.”
Hedged versus unhedged share classes
| Fund | Share class | Return over one year (%) | Return over three years (%) | Return over five years (%) |
|---|---|---|---|---|
| Jupiter Japan Income | Unhedged | -13.1 | 3.5 | 6.6 |
| Jupiter Japan Income | Hedged | -6.9 | 9.7 | 7.7 |
| Lindsell Train Japanese Equity | Unhedged | -13.1 | -5.6 | 1.1 |
| Lindsell Train Japanese Equity | Hedged | -3.8 | 2.0 | 4.3 |
| Artemis European Sustainable Growth | Unhedged | -21.9 | -1.3 | 0.1 |
| Artemis European Sustainable Growth | Hedged | -24.2 | -1.5 | 0.4 |
| JPM US Equity Income | Unhedged | 20.2 | 11.7 | 13.2 |
| JPM US Equity Income | Hedged | -4.1 | 6.1 | 7.1 |
| Schroder Tokyo | Unhedged | -8.2 | 1.6 | 2.5 |
| Schroder Tokyo | Hedged | -3.6 | 6.9 | 3.1 |
Source: Morningstar. Total return data to 23 September 2022. Past performance is not a guide to future performance.
These articles are provided for information purposes only. Occasionally, an opinion about whether to buy or sell a specific investment may be provided by third parties. The content is not intended to be a personal recommendation to buy or sell any financial instrument or product, or to adopt any investment strategy as it is not provided based on an assessment of your investing knowledge and experience, your financial situation or your investment objectives. The value of your investments, and the income derived from them, may go down as well as up. You may not get back all the money that you invest. The investments referred to in this article may not be suitable for all investors, and if in doubt, an investor should seek advice from a qualified investment adviser.
Full performance can be found on the company or index summary page on the interactive investor website. Simply click on the company's or index name highlighted in the article.