The surprising impact of currency

Andrew Morris: “Even in the short history of the euro, UK investors would have earned a 21% return simply by holding euro-denominated assets since the launch of the currency in 1999.”

In his latest monthly column on investment risk, Andrew Morris considers the impact currency can have on portfolio returns and what can be done to ensure an appropriate exposure is maintained to both UK and overseas assets

Having looked at portfolio rebalancing and the distortion of risk, I thought it prudent this month to consider an oft-forgotten driver of investment returns – currency. When picking up the KIID of a fund with overseas exposure, you will see the risk of ‘currency movements in the value of overseas assets may impact the value of the fund’ often cited. But just how much of an impact do they have on the returns generated by a UK investor?

At the most extreme, one only has to look at the example of Russia in 2014. Following the military incursion into Ukrainian territory and the ensuing sanctions, it would be easy to assume the value of Russian companies duly plummeted and left the domestic stockmarket in dire straits.

Yet, although the equity market performed poorly – losing 12.5% in rouble terms – it was the currency impact that harmed overseas investors. UK holders of an MSCI Russia index tracker would have lost 42.9%, simply because the rouble depreciated so much against sterling. This currency risk is one that is often forgotten about when allocating overseas – particularly as currency movements often outweigh the individual share price movements

In other instances, of course, UK investors can benefit from currency swings. Indeed, one of the best trades UK investors could have made over the last century is to hold overseas assets. In general, sterling has significantly depreciated versus most major currencies over this timeframe, earning UK investors a positive return in the process.

As an example, the following graph highlights the path of sterling against the US dollar – the US being one the most commonly held overseas markets – over the last 50 years. Furthermore, even in the short history of the euro, UK investors would have earned a 21% return simply by holding euro-denominated assets since the launch of the currency in 1999 and 45% since the peak in May 2000.

Sterling’s path versus the US dollar over the last 50 years

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Source: Bank of England, as at 07/0717

What does this tell us?

Unsurprisingly, one of the most important lessons from this is investors should maintain a well-diversified portfolio, with a mixture of asset classes, both at home and abroad. This also highlights, however, why an investor’s mind-set should not be dominated by a ‘home country’ bias, as you would miss out on the potential for significantly higher returns compared with a purely domestic portfolio.

This is why we believe risk-targeted solutions offer piece of mind to advisers, as they stick rigidly to asset allocation limits that are suitable for a particular client’s risk appetite. Overseen by independent agencies, these asset allocation limits include both asset class and domestic versus overseas exposures. Typically, multi-asset portfolios are constructed, with a ‘risk score’ of between 1 and 10. A client’s risk score would then be matched to the relevant portfolio.

As an example, a client with a risk level suitable for a ‘Portfolio 3′ should have 24% in overseas assets. In contrast, this rises to 55% for a ‘Portfolio 7′ client. This highlights the greater risk prevalent in investing in overseas assets, but is also an indication of the potential return.

Much has been made in the press of late how UK investors typically rely too much on purely UK assets. Greater weight needs to be placed on sources of return generated from outside the UK and a strict and disciplined managed portfolio solution is an excellent way to maintain an appropriate exposure.

There will, however, be some clients for whom any overseas currency exposure would be deemed too risky. In this instance, it is important to remember much of the revenue generated by the UK’s largest companies does in fact come from overseas.

More than 70% of the revenues generated by FTSE 100 companies, for example, comes from outside of the UK, as does 50% of the revenues generated by the FTSE 250. As such, in instances when overseas assets are not suitable, UK equity exposure within a managed fund could go some way to addressing this imbalance.

Andrew Morris is sales manager at Canada Life Investments

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