Currencies Confused Revisited
There are few things in life more frustrating than dealing with currencies. Maybe that is why so many people choose to ignore them altogether when it comes to their investment strategy. But sticking your head in the sand has rarely proven to be a successful strategy, and the risks are simply too high to be left unaddressed.
So, let us start with the most obvious observation when it comes to currencies: they matter, big time. Most of us have noticed the value of GBP plummet from more than 2 to nearly 1, versus the value of USD. Something to do with a global financial crisis and some sort of minor political incident called “Brexit”. But the reasoning never matters. What matters is that our GBP assets are now worth about half of what they used to be, when compared to the rest of the world (e.g. the USD, which is involved in nearly 88% of global currency transactions – HSBC, 2016).
Of course, you could argue that you only need GBP to pay your bills and live your life, and aren’t we just talking about the random holiday to Europe anyway, which is now (granted) a bit more expensive? Yes, you could, but we live in a global world. And whereas you could think of yourself as an island (maybe even Ibiza, like Hugh Grant’s character in the underrated movie About a Boy), your local businesses are not. They need to import goods and services from abroad and falling currencies cause inflation, which would mean interest rates need to go up, which makes the price of living more expensive. This is but a small example of the detrimental effects of currency devaluations. You may also want to cast your eyes towards Turkey or Venezuela, if you still think currencies don’t matter.
So, the obvious conclusion regarding managing currency risk is not yes or no, but how much? In other words, how much of our currency exposure do we want to hedge, by investing in USD or EUR assets, for example? This is where it gets interesting, and we have talked to a lot of esteemed people and pedigreed professionals about this. It seems, no one knows. Some advisers think it should be 35%, others 80%. Some let it float entirely, relying on the thesis that in the long run currencies don’t matter. While that may be the case, that doesn’t help us much with our short-term problem: whereby we lost half of our money (in relative terms). Let’s dismiss with the obvious, if you hedge too much, you are taking a (big) view on one currency (and economy). There are also the hedging costs to consider (a.k.a. the ‘interest rate differential’), which are huge at the moment and in excess of 1.5% per year. On the other hand, if you don’t hedge at all, you run the risk that your local purchasing power could diminish, if GBP were to appreciate.
That leaves only one very simple solution: you do half. And there you go, if there is one universal truth to every prudent investment decision, whenever faced with an impossibly difficult decision to make, you just go half pregnant. After all, if half of your GBP assets go up in value versus everything else, you would be happy. Equally, if they were to go down, you would also be happy, because you only lost half and you could even buy more at a discount.
Please also see our earlier post Currencies Confused for more of our thoughts.