Did you know that the value of your money changes all the time. It might not impact your day-to-day spending, but the value of the pound is always shifting against foreign currencies, like the euro or US dollar.
Chances are, you'll have seen this for yourself when exchanging currency to go abroad. Whether that’s buying euros at the Post Office or seeing the exchange rate listed on your bank statement. The exchange rate you receive will change just how much you need to pay in pounds – so if the pound is stronger than the Euro, you could feel like things are much cheaper to buy.
When you're dealing with much larger sums than what you take on holiday, currency exchange becomes a much bigger issue.
What is currency hedging?
Currency hedging is a way of reducing the level of risk on your investments. For example, if you held all your investments in pounds and the value of the sterling dropped, then the value of your entire portfolio would drop as well.
“Hedging” is holding investments in different currencies with the aim to reduce the impact that your portfolio will see from swings in exchange rates. It might even be the same investments, but instead of holding them all in pounds you ‘hedge’ and hold half of those investments in US dollars. This way, if the value of the pound falls against the dollar, then the half held in pounds will fall but the half held in dollars will increase – in this specific example, your overall change due to the exchange rate should be zero.
Why is currency hedging useful? There’s a lot of potential uses for hedging, especially if you own shares in global companies, like Apple or Amazon. This is because your returns with these companies are determined by two factors:
- The performance of the investment you hold, such as shares in Apple.
- The exchange rate between the pound and the foreign currency that investment is bought in (for example, the Apple might be in US Dollars).
On this second point, the dollar/pound (also shown as USD/GBP) exchange rate will affect the amount of return you could receive on those shares. In this situation, hedging currency could reduce the effect that you’ll see from any changes in the USD/GDP exchange rate and therefore reduce the risk.
What is an example of hedging?
It can sometimes be easier to understand with a simple comparison.
Let’s say there are two UK investors, and both bought the same amount of shares at the same time using US dollars. Investor One chose to hedge their investment and Investor Two did not.
If those shares went up by 50%, then both investors make an impressive return.
However, the amount of return each will receive will be different, despite having identical holdings bought at an identical price.
This is because you’ll also need to factor in the GBP/USD exchange rate. Why? Let’s say both investors chose to sell at the exact same time as well, they’d sell their shares in the same currency they were bought in – US dollars – but would then convert it back into pounds as they live in the UK.
As Investor One hedged their investment, they’d see the full 50% profits from that sale. However, during the time they were invested, the pound had increased in strength against the dollar, which means that Investor Two wouldn’t see the full 50% increase – as they’d lose out at whatever the exchange rate was when they sold. The larger the gap in the exchange rate, and the greater the amount invested, the more this can impact the overall profits.
By hedging their investments, Investor One was able to protect themselves against exchange rates.
When should you Hedge?
Deciding when to use a hedging strategy against currency is an extremely difficult task. You may have seen the ‘currency’ section in our Month in the Markets updates, which shows how performance in certain currencies can support or decrease the gains seen in our plans.
It’s also worth noting that hedging isn’t always necessary. Wealthify’s investment team looks at many different factors to make this decision to hedge funds. Our experts take into account things such as the type of investment, how the global economy looks, and the volatility of currency movements before deciding whether to protect their investment returns from changes in foreign exchange rate movements
Please remember the value of your investments can go down as well as up, and you could get back less than invested.
Wealthify does not offer advice, if you’re not sure whether investing is right for you, then please speak to a financial adviser.
