Funds offer ‘currency protection’
The FTSE 100 has enjoyed successive days of gains, clocking up returns approaching 5pc since the start of the year. Much of this is driven by currency movements, as sterling continues to fall. This week the currency hit its lowest level since the “flash crash” in October last year, when the pound dropped by 6pc overnight.
Mining and oil companies have also contributed to the rally, with many getting their earnings overseas in currencies that are stronger than the pound, and so benefiting from a boost.
While the gains are great news for investors now, the currency effect on returns shows how vulnerable investors are to exchange rate moves.
One way to eliminate this risk is to use a “hedged” share class, which many popular funds offer.
These “hedged” funds use currency exchange contracts to cancel out the impact of exchange rate movements on an investment.
If all of the foreign currency exposure of a fund is hedged against, the return should only come from the actual movement of the stocks held – as if you owned them in their local currency. This can be beneficial or not, depending on what happens to exchange rates.
For example, the non-hedged share class of Sarasin’s Thematic Global Equity fund returned 29pc over the past year, but the hedged share class returned only 10pc.
This is because the fund is 60pc invested in the US, and the pound weakened against the dollar.
Conversely, the non-hedged share class of the UBS Life Japan Equity tracker fund returned 33pc between January 2012 and January 2015, whereas the hedged share class returned 93pc.
Over that period, the pound strengthened significantly against the Japanese yen. Returns from the regular share class were hurt by being converted back into a stronger pound.
Here are a few other things to bear in mind. Some hedged share classes aim to offset 100pc of the foreign currency exposure, while some may only hedge part of the exposure.
There are more transaction costs involved in running a hedged share class. The manager is also likely to charge a higher fee.
Hedged share classes are most common among bond funds. A number of equity funds offer them, but don’t assume they will.
Profitable hedging: investors in Japan saw the yen fall against the pound last year