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To Hedge or Not to Hedge FX Risk?

‘Whether ‘tis nobler in the mind to suffer the slings and arrows of outrageous fortune, or to hedge against a sea of troubles…’ (apologies to Shakespeare for badly misusing his words…).

 

That is indeed the question (ha!) that many investors worry about. It is one thing to invest in a foreign stock market, it is another to suffer the consequences of FX moves. For UK investors this is a particularly important consideration as many investable markets are outside of this island nation. And the GBP swings a lot!

 

At Tricio we fully understand the consequences of FX moves, all three of the founding members have deep experience in wholesale FX markets. We have over 100 years of combined experience at the last count – yikes! Big currency swings can happen overnight. Two examples stand out, the Swiss National Bank decision to abandon their EUR/CHF floor in 2015, and the result of the UK EU referendum in 2016. Currency moves can also unfold over years, like the EUR/USD fall from $1.60+ to below parity from 2008 to 2022. The currency move can boost investment returns, or drag on returns. FX moves are notoriously difficult to forecast on a consistent basis though. My own experience in dealing with FX risk in investments (not currency trading, but dealing with the FX as part of investing in bonds or stocks) is that in general I prefer to embrace the currency risk as part of the investment. Fund managers that I have worked with (bonds and stocks) generally take that view as well – the currency risk is part of the investment decision.

 

The chart below shows the indexed returns of investing in an S&P 500 ETF (accumulating). The blue line is the hedged version of this exposure. The yellow line is the USD ETF – which is what USD based investors would be receiving. The red line is the ‘mark-to-market’ yellow line index revalued in GBP terms at the end of every month. In other words, the unhedged S&P 500 USD ETF for GBP based investors. It is clear that the strong USD (soft GBP) boosted the red line (unhedged) from summer 2016 onwards – the consequences of Brexit boosting USD returns for GBP based investors.  

 

 

One market that is interesting for investors at the moment is the Japanese stock market. Indices are at new highs for this cycle and the JPY is clearly on a back foot. The chart  below shows the GBP/JPY cross rate. It is interesting to note that the Brexit hit to the GBP has been regained in this cross rate (stronger GBP, weaker JPY since early 2020).



For stock market returns? The indexed chart below shows a GBP hedged TOPIX ETF, a JPY ETF and the JPY ETF revalued to GBP every month. All of the lines converge now, suggesting that the last near decade of returns has seen FX concerns reduced to a ‘tale told by an idiot, full of sound and fury, signifying nothing’ (again, sorry WS). Realistically though, this makes current FX decisions by investors really important now. If the JPY falls a lot faster and further then hedging this risk will be worth considering. If the view is taken, as we do at Tricio, that the JPY is going to hold steady or actually firm from current levels (aiming for Y165 over the next 12 months) then leaving the investment to run in JPY (unhedged FX) may be worth thinking about. Easy, right? Well….

 



 

 Gerry Celaya, Chief Strategist


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