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Currency fluctuations are a key concern for both professional and individual investors. Managing currency exposure is crucial in a globally diversified multi-asset portfolio and plays a significant role in asset allocation decisions. Depending on the asset mix, currency risk can considerably affect portfolio returns and volatility, as well as serve as a source of diversification.
At Nutmeg, we manage currency risk by utilizing currency-hedged exchange-traded funds (ETFs), which effectively mitigate the impact of foreign currency exchange rates over time. This article delves deeper into the concept of currency hedging.
Do My Investments Lose Value If the Pound Drops?
It’s understandable to worry about the value of your foreign investments in light of events like Brexit and their impact on the pound’s value against other currencies. While the value of the pound (GBP) remains volatile, responding to various news events, Nutmeg believes that a positive resolution to the long-standing Brexit negotiations is likely to bolster the GBP. Conversely, a no-deal exit from the EU could lead to a drop in its value.
Therefore, it’s essential for investors to recognize and proactively manage the currency risk in their investment mix. At Nutmeg, we take a proactive approach to managing currency risk in our fully managed and socially responsible portfolios. Our investment team continually assesses and adjusts each portfolio’s exposure to foreign currencies, aligning with the specific risk levels and asset allocations. This involves determining both the proportion of overseas assets and the degree of exposure that should remain in local foreign currency versus what should be hedged back into GBP.
What Is Currency Hedging?
Currency hedging is an investment strategy aimed at protecting the value of foreign investments from currency depreciation.
For example, consider a core holding in our portfolios that provides exposure to U.S. large-cap companies through the S&P 500 index, which is valued in U.S. dollars (USD). The investment’s worth in GBP is influenced by the USD to GBP exchange rate at the end of each trading day.
If we anticipate that the GBP will weaken, we may choose to hold the investment unhedged, allowing our returns to benefit from favorable exchange rate movements. Conversely, if we expect the GBP to strengthen against the USD, we may partially hedge that exposure to buffer against potential losses from currency depreciation.
The Dual Nature of Currency Risk
Currency risk operates in both directions. If the GBP does not move as expected according to the hedging strategy, investors may face implicit “opportunity costs,” missing out on potential gains from a stronger foreign currency. To minimize these opportunity costs, Nutmeg employs partial hedges instead of full hedges. Our strategy carefully sizes hedges, ensuring they align with the foreign currency risk appropriate for each portfolio’s risk target.
In addition to opportunity costs, there are two explicit costs associated with hedging. The first arises from slight increases in fund fees for hedged ETFs, reflecting the additional management processes required by the ETF provider. The second cost relates to the setting of the hedged currency price, influenced by the difference in short-term interest rates between markets. This second cost is factored into the ETF’s daily price.
Think of hedging via ETFs as a cost-effective, all-in-one solution that leverages the economies of scale provided by major ETF providers. This approach offers a low-cost, risk-managed tool for navigating currency risk in portfolios.
As the situation surrounding Brexit unfolds, Nutmeg expects ongoing GBP volatility. Our team remains dedicated to actively managing the currency mix to effectively handle risk and maintain well-diversified portfolios.
Risk Warning
As with all investments, your capital is at risk. The value of your Nutmeg portfolio may fluctuate, and you could receive less than your initial investment. Forecasts are not reliable indicators of future performance.
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