Should I Worry About Currency Risk?

This little cheeky chappy is a cane toad.

G’day. Image credit: Shutterstock.

Back in the 30’s, Australian sugar cane farmers had a bit of a problem on their hands with beetles destroying their crops.

Adult cane beetles would eat the leaves of the crop, and lay their eggs in the roots. When the larvae hatched, they would munch on the roots and kill the cane from the ground up.

Pesticides weren’t really an option back then either, as they were still in their infancy and relatively expensive. So the Australians borrowed an idea which had been utilised successfully in Hawaii - using cane toads, a natural predator, to control the beetle population.

In 1935, 102 cane toads were brought from Hawaii and bred - within a year, over 60,000 toads were released across Queensland. Job done.

Only, the Australians managed to solve one problem by creating an altogether, much bigger one.

Cane toads, it turns out, are apex predators - they will eat absolutely anything. Not only that, but they breed like rabbits and are lethally toxic. Any animal that tired to eat a cane toad would end up keeling over minutes afterwards.

The Aussies swapped one invasive species, for an altogether much more troublesome one. A decision that permanently altered the entire ecological make up of the country.

They sorted one side of the equation, but forgot about the other. And it bit them on the bum.

Which brings us neatly onto the notion of currency risk.

Currency risk refers to the risk that when we buy a security denominated in a foreign currency, the value of that currency depreciates versus our home currency (the one we spend the majority of our money in). If this happens, when we come to sell the investment it is “worth less” in our home currency than it would otherwise have been.

In other words, you can buy an asset which goes up - but you can end up losing money if the currency moves against you. You can get one side of the equation right, but lose out on the other.

At the moment UK listed stocks, priced in Sterling, represent around 3.5% of the total global equity market. So if we are investing into a global market index, one of the risks we are accepting is currency risk.

Now, currency moves have largely been a tailwind for UK investors over the past ten years - but there is no denying that Sterling could strengthen and if it did the currency would turn into a headwind.

Source: Yahoo Finance. Returns are shown for Sterling (GBP) versus the Dollar (USD - in red), the Euro (EUR - in blue) and the Swiss Franc (CHF - in yellow) over the past ten years.

How can we look to manage out this currency risk? And should we even bother?

If currency risk keeps you awake at night, there are a couple of ways to hedge it out.

The first, and most simplistic, is just to buy assets denominated in Sterling.

But I think this is a really bad idea for two reasons. First off, buying only UK stocks means you are cutting out the rest of the world - massively reducing your diversification and subsequent potential for returns.

The below chart neatly demonstrates just how painful this decision can be.

Source: FE Analytics. Chart shows the total return for the MSCI World global equity index relative to the FTSE All Share index in GBP terms, dividends reinvested, during the past ten years.

Only investing in UK stocks to hedge out currency risk also makes no sense because the companies themselves are chock laden with currency risk.

BP, Diageo, Unilever - they all generate revenue in currencies other than Sterling. In most cases way more.

Indeed, this is the case around the world and one of the reasons I think worrying too much about currency risk is a fool’s errand. Global companies earn global revenues - you’ll never be able to get rid of all the underlying currency risk. And if you try you’ll tie your brain up into a pretzel.

At the moment, US listed stocks (denominated in Dollars) make up around two thirds of the global equity market. Which is a lot. But by some measures 80% of global trade is invoiced in Dollars - so arguably, if anything, the global equity market is actually optically underweight USD.

The other obvious way to hedge out currency risk, is to invest in funds which do this for you.

There is a cost to hedging however - to give you an idea of how this can look the iShares S&P 500 Sterling Hedged ETF costs 0.2% a year, while the simple unhedged version costs 0.07%. So almost three times as expensive.

If currency risk really is a massive concern to you then these funds are a decent option. But honestly, I really wouldn’t bother. To me, currency hedging is a solution looking for a problem.

As I have already mentioned, these companies earn revenue and earnings in all sorts of currencies - so there is currency risk baked into the underlying business, even if you are buying the stock in your home currency.

Hedging out currency risk within your equity allocation may work out for you, it may not - but it doesn’t seem to have any mitigating impact on the volatility that is a hallmark of equity investing. You aren’t making your investing journey any smoother by currency hedging.

Source: Dimensional. Returns for currency hedged stock and bond returns are shown in turquoise, unhedged are shown in grey.

Where mitigating currency risk does seem to have an impact though, is within a fixed income sleeve (as you can see from the second chart above).

As a rule of thumb, the shorter the investment timeframe the more we need to be concerned about all risk, not just currency fluctuations. If we are going to need the money within the next three years or so, it should be denominated in or hedged to the currency we are most likely to spend it in.

So our “financial bulletproof vest” (our cash savings) should always be in the currency we expect to spend them in. In a similar vein, our bond allocation should always be hedged into Sterling (or whatever our home currency is) as this sleeve can be used to meet expenses before our stocks do.

Past performance is not indicative of future returns. None of the above is intended to constitute advice to any specific individual. If you have questions regarding your situation, please consult with a regulated financial adviser.