Sep 11, 2020

Everything you need to know about currency risk

How dangerous is currency risk for investors? When is it worth hedging and when not?

  • Currency fluctuations can massively impact on an investment’s success.
  • However, investors with a long-term horizon can often eliminate currency risk in equity funds without hedging.
  • Bond funds, by contrast, are more susceptible to the impact of currency risk.
4 minutes to read

Autumn is coming - but the US dollar is still firmly in the summer doldrums. Since mid-April, it has been losing value against the euro. By August, the euro exchange rate had risen to around 1.20 dollars - from under 1.10 dollars in early summer. The European currency seems to be one of the few winners from the Coronavirus crisis. But that did not necessarily help euro investors with dollar-denominated allocations. For them, the dollar’s weakness was a clear disadvantage.

For example, the S&P 500, the broad-based US stock-market index, rose by a satisfying 8.35 percent in dollars from the start of the year to the beginning of September 2020. Calculated in euros, however, the gain amounted to just 2.57 percent.

Should investors therefore act and hedge currency risk? The answer is: it depends.

Currency risk is a significant part of overall risk

Currencies usually fluctuate because of budgetary decisions or interest rate movements, or when trade balances change or geopolitical crises erupt. Currency fluctuations are therefore a daily phenomenon worldwide.

Calculations show that currency risk can account for up to 40 percent of total investment risk when allocating to foreign stocks.[1]

A closer look reveals that between 1975 and 2009 almost 36 percent of the total risk of broadly diversified, short-term investments in US equities was due to exchange-rate fluctuations. For Japanese equities the impact was almost 30 percent and for UK equities over 28 percent. [1] It therefore looks like investors in the EU cannot easily ignore currency fluctuations.

Currency risk can contribute up to 40 percent to the investment risk for overseas shares.

Over a long time period, differences in equity returns due to exchange-rate fluctuations usually even out.

A long-term horizon can obviate the need for hedging

But there is a compelling counter-argument to this: funds are generally not invested to maximise short-term profits but for long-term asset accumulation. The longer the investment horizon, the more likely it is that the effect of currency fluctuations will be lost, meaning there is less need to hedge the currency risk through futures.

For example, if you compare one of the world's broadest stock-market indices, the MSCI World, with its currency-hedged counterpart, the MSCI World (Hedged), you will find that the difference in returns almost evens out over a 20-year period. In this case, investing in the more expensive hedged variant would therefore not have paid off in the long term.

Hedging can make sense for overweight countries and bonds

However, hedging can be useful if your portfolio has an unusually high weighting to a particular foreign currency, especially if that currency has proven to be much more volatile than the dollar, euro or yen in the past - as is the case with the Turkish lira, the South African rand and the Argentinian peso, for example.

Similarly, when investing in bonds, there are many arguments for hedging currency risk. This is because bond funds are generally more susceptible to currency risk. Statistically, the world's major currencies fluctuate by around 10 percent per year. They are thus twice as volatile as US government bonds but only half as volatile as equities.[2]

Currency hedging can be useful for bond funds

Bond fund yields, which are in any case lower right now due to the current low interest rate phase, can thus be eaten up by exchange-rate fluctuations much faster than equity returns. If you do not want to take the risk, you may pay slightly higher fees for a hedged variant but you will no doubt sleep better.

In conclusion, the longer the investment horizon, the less investors need to hedge their foreign-currency investments. For equities in particular, currency risk can almost vanish over a long investment period - because investors sometimes profit from currency movements and sometimes lose. However, investors should think carefully about currency risk when allocating to bonds and traditionally more volatile currencies, such as those in emerging markets.

Major global currencies fluctuate by around 10 percent per year.

S&P 500 performance over the last five years

Year

08/15-0816

08/16-08/17

08/17-08/18

08/18-08/19

08/19-
08/20

Performance

12,6%

16,2%

19,7%

2,9%

21,9%

Past performance is not a reliable indicator of future performance

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1. Source: https://fairvalue-magazin.de/waehrungsrisiko/

2. Source: https://www.dasinvestment.com/currency-overlay-strategien-das-geheimnis-um-die-waehrungsabsicherung/

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