Why is currency important when investing?
In a nutshell
When you invest in a fund that has interests outside the Eurozone, you’re exposed to the investment risk of the assets, as well as the risk of the foreign currency.
What does that mean for investment performance?
If you’re in a fund that invests in a named foreign currency, it’s important to understand the difference between any return delivered from the assets and the currency.
Your fund may be priced in Euro, but the assets it invests in are valued using the foreign currency, so performance will vary depending on how that currency is holding up against the Euro.
How is asset risk managed?
Fund assets are diversified and the percentage split is weighted depending on the risk profile of the fund. By spreading the asset allocation between bonds, property and equities for example, fund managers can seek out gains while managing the overall risk.
Can the risk of movement in exchange rates be managed?
Some fund managers try to protect against it and some don’t.
Currency hedging is the strategy for trying to protect a fund against movements in the currency it invests. If an investment is fully hedged, movements in the underlying currency won’t impact the value of your investment in Euro and your risk will be limited to the return of the assets.
Partial currency hedging is also employed by some fund managers. With this approach, movements will still have an impact on the value of your investment, but there’s some level of protection offered. With a partial hedging, the level of hedging applied can depend on the fund manager’s view, how they expect the currency to move against the Euro and whether the expected movement could result in a gain or a loss for the fund.
How does that work in practice?
Let’s say you invested in a fund that tracks the S&P 500 index – a US stock market index that follows 500 large companies listed on the New York Stock Exchange or NASDAQ stock exchanges.
From the 21st of February 2017 to the 16th of February 2018, the S&P 500 index returned 15.51%. From an investor’s perspective, that looks like great news, but remember the fund is denominated in Euro and it's tracking stock that’s in US Dollars, so exchange rates come into play.
That means your return will be affected by:
- The return of the US stocks and
- Movement in the Euro and US Dollar exchange rates
Either of which could increase or reduce the 15.51% figure mentioned before, sometimes significantly.
How do you work out the investor return?
What would the investor return be in this example?
In this case, the US Dollar to Euro exchange rate (also known as FX) returned 15.46% over the same period. That’s not the same good news story for the investor unfortunately, as the actual return for the Euro fund would be -2.35%.
Having seen the headline figure of 15.51%, -2.35% would naturally be disappointing, and that’s the lesson here. A fund with a currency movement dependency takes on a different level of risk and that can have a big impact in on any losses and gains you stand to make.Source: Exchange rates, Central Bank, 20/02/2018 Index returns: Yahoo Finance
The graph below helps illustrate the daily closing prices of all three variables over that one-year period.
Source: Exchange rates, Central Bank, 20/02/2018 Index returns: Yahoo Finance
As an investor, what should you do?
If you’re considering a fund that that’s exposed to a currency outside the Euro, we recommend talking to your financial advisor and asking about hedging upfront, so you understand how the fund works and the risks involved.
Irish Life provides life insurance, pension and investment plans and recommends getting professional financial advice before making financial decisions.