The investment trick fighting inflation, and limiting bear market damage

Sam Benstead explains what has cushioned the impact of falling markets for investors who own American stocks.

News of a bear market in US shares, which also dominate global indices, means investors are preparing for the worst before checking their portfolios.

But on opening their accounts, UK investors are getting a pleasant surprise: their returns are probably only half as bad as they predicted.

While the S&P 500 index and the MSCI World index have dropped 23% from their high point in early January, UK investors in funds tracking these markets have lost only about 14%.

What has saved them is a strong American dollar. One pound today buys $1.20 compared with $1.35 at the start of the year. There’s been a 10% drop since January, and 12% over the past 12 months.  

This means that assets priced in dollars are now worth more in pounds, which has cushioned the impact of falling markets for investors who own American stocks.

We explain why this has happened and break down what investors should do to best manage currency changes in portfolios.

Why has the dollar strengthened?

The US dollar is considered a safe-haven asset due to its dominance in the global payments system (most countries hold dollar reserves and commodities tend to be traded in dollars) and the credibility of US institutions and their support for the American economy, the largest in the world.

This means that in times of market stress, investors turn to dollars. Rising inflation globally and crashing stock markets therefore mean that demand for dollars has shot up.

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Even if the market storm is in America, the thinking is that other countries will probably suffer more than the US, so the dollar is still a safe bet.

The other force propelling the dollar is the willingness of the US Federal Reserve to raise interest rates. Higher borrowing costs mean that investors can get a better return on their cash, so they buy dollar-denominated debt for the higher income that’s being generated.

The Federal Reserve now has rates at 1.75% and economists expect a 0.75 basis points rise in July. In contrast, rates in the UK are 1.25% and zero in Europe.

Will the dollar keep rising?

The bull run for the dollar could be running out of steam, however. George Saravelos, global head of foreign exchange research at Deutsche Bank, says the dollar is overvalued.

He said: “The market has hoarded a huge amount of dollars in recent months – equivalent to Lehman, Covid or the Trump trade war – leading to a very substantial dollar overvaluation.

“There are many approaches to assessing dollar valuations. On a simple real effective exchange-rate metric, the dollar has now exceeded its 20% valuation bounds, which has historically been a strong mean reversion signal.”

While the dollar is currently expensive, Saravelos notes that a large, global risk event could lead to an even more valuable dollar as investors would retreat to a safe asset.

Should you buy hedged or unhedged funds?

Most investors are in unhedged funds, meaning that currency fluctuations affect their returns. This has been great news for global and US investors this year, such as those owning the giant Super 60 members iShares Core MSCI World ETF (£38 billion) or Vanguard US Equity Index (£11.4 billion).

However, many active and passive funds do offer hedged alternatives, for a higher fee. For example, iShares Core MSCI World UCITS ETF has a hedged version (ticker IWLE) that uses derivatives to try and eliminate currency risks. It costs 0.3% a year compared with 0.2% for the unhedged version.

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BlackRock’s hedged Core S&P 500 ETF (ticker IGUS) costs 0.2% compared with 0.07% for the unhedged version.

On whether investors should hedge currency risk, Ben Yearsley, investment director at Shore Financial Planning, said: “In most scenarios, it’s better to leave your portfolio unhedged as there will be so many natural hedges in the portfolio. Don’t forget that global companies are already hedging out currency movements themselves.”

However, he said that the steep fall in the pound versus the dollar this year meant that this could be a good time to buy hedged US or global funds.

He said: “This could be an opportunity to add some hedged share classes – however you need to remember there is an additional cost to hedging – and with US interest rates moving far quicker than sterling, the cost is increasing.”

One area where currency hedging is popular is bond funds, particularly emerging market debt funds where big currency swings are common due to volatile inflation and interest rates, such as in Turkey, Argentina or Brazil.

However, Yearsley says that he does not think any specific area should or shouldn’t be hedged.

He said: “It’s more about the risk an investor is willing to take. Removing currency from the equation removes a portion of volatility but also removes something that could give you a potential positive return.”