What currency hedging is and why it’s important

For most UK investors, the Great British Pound (GBP) will be the primary investing currency. When building a globally diversified portfolio, however, it’s important to consider how exposure to overseas markets could benefit your investments.

Through InvestEngine, investors have access to hundreds of ETFs, with some of them tracking multiple geographies or offering exposure to overseas markets.

How different currencies affect investors

When investing in foreign markets through ETFs, investors are primarily taking on two forms of risks: the risk of the underlying market falling or increasing in value (for example the S&P 500 in the United States) and the performance of the overseas currency falling or increasing in value (in this case, the US Dollar).

When you invest in the S&P 500 as a UK or GBP-based investor, you’ll have to convert your GBP into US Dollars. This makes you susceptible to movements in the currency throughout the time that you’re invested in the market.

When looking to cash in the investment, you will once again need to swap those US Dollars back to your base currency of GBP. In doing so, you’ve exposed yourself to the currency fluctuations that have happened throughout the investment period.

If the US Dollar depreciated over the period, it would buy you less GBP. In turn, this translates to a lower investment return.

So, the performance of the underlying currencies in your portfolio can help or hinder your investment returns.

What investors can do

There are a series of ETFs in our platform which mitigate the risk of overseas currency exposures by being ‘foreign-exchange hedged’. By investing in these, investors are investing in an overseas market without taking on the currency risk.

As an example, the returns of the S&P 500 for the last year would have 46.5% for the last 3 Years if the currency was left unhedged (meaning the investor is taking currency risk) and 26.0% if the currency was hedged (meaning the investor is not taking any currency risk). The decline in the value of sterling versus the dollar has boosted investment returns in the US.

The charts below show the total return performance of an S&P 500 GBP hedged ETF (XDPG, in blue) and the S&P 500 index on an unhedged currency basis (in orange). Rebased to 100.

1 Year:

3 Year:

5 Year:

This disparity has only become more relevant in a time when the GBP has been depreciating against the US dollar by -10.7% in one year, reaching its lowest-ever value recently.

Some investors choose to hedge their exposure to overseas currencies as the added safety net and unpredictability of foreign exchange markets is something that very few can forecast. Others prefer to leave the exposure unhedged as exposure to foreign currencies can also add another layer of diversification. 

Returns are expressed on a total return basis

Source: Bloomberg

Date of data: 11/11/2022

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