ETF currency risk: How to handle it

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ETF currency risk: How to handle it ETFs let you own the world. Within the space of a few funds, you can invest in every major country and publicly traded asset class - enabling you to harness the power of diversification, juice your returns and reduce volatility. What’s less well understood is that overseas investing exposes you to currency risk. It makes no difference whether you use ETFs or direct investments. The most beautiful increase in value or dividend strategy is of little use if an unfavourable exchange rate cancels out the return or even drags it into negative territory. There are indeed insurances against exchange rate fluctuations, so-called currency-hedged ETFs. But first, you should assess how much of your own investment actually depends on the development of foreign currencies.

  • Your US equities fall by 5% when their value is converted into pounds - the currency you pay your bills in as a UK resident.

Exchange rates create opportunities and risks for ETF investors 

Exchange rates create opportunities and risks for ETF investors
Source: justETF Research
Exchange rate fluctuations also add to and subtract from the local returns of overseas securities. For example, if US stock market prices dropped 5% while the dollar simultaneously lost 5% against the pound, then a UK investor would see a 10% total loss (-5% local return plus -5% dollar: pound return).

If the US stock market had increased 5%, then a UK investor would register a 0% return - the local gain is wiped out by the adverse exchange rate move.

Again, this works in reverse. If the dollar strengthened 5% in tandem with a US stock market 5% rise, then a UK investor would gratefully accept a 10% total return. If the US market lost 5%, then the strengthening dollar compensates the UK investor for the loss, and they end up with a 0% return. Meanwhile, a US investor would be sitting on a 5% loss.
The same goes for any security that’s priced in a foreign currency. Your returns equal the change in the local value of the security, plus or minus the change in the exchange rate.

Currency risk can make a big impact in the short term. An overseas market can make decent annual returns that are nullified by a strengthening pound. Or a weakening pound can supercharge your overseas assets - as happened in 2016 when the pound sank 20% against the dollar. The returns of certain strategies can be entirely drowned out by the volatility of exchange rates, think Emerging Market bonds denominated in local currencies.

Currency risk of ETFs: Should you fear it?

Your time horizon matters. Your vulnerability to exchange rate volatility increases if you need to sell your investments in the short run. Exchange rate fluctuations can be violent - as the Brexit vote aftermath has shown. Volatility is particularly dangerous for forced sellers who can’t just ride it out, so you may well want to protect your portfolio from currency risk if you must regularly draw down from it.

Longer-term investors have much less to worry about and may even benefit from currency risk. Studies show that exchange rate fluctuations make little impact on equity returns as time horizons lengthen. Economists who advocate Purchasing Power Parity between countries believe that currencies reach equilibrium over time, and therefore exchange rate fluctuations tend to net out. Many commentators believe that there’s no expected return from taking currency risk, but that it can reduce the volatility of your holdings by reducing the correlation of returns between overseas assets held in different currencies. In other words, global equities will naturally tend to hedge each other as rising currencies are offset by falling ones.

What’s your currency risk exposure?

The MSCI World index illustrates how you can work this out. The index tracks the stock markets of 23 industrialised countries, as you can see in the diagram below. It’s dominated by the US. About two-thirds of an MSCI World ETF is invested in US equities, and those assets are priced in US dollars. In other words, a UK based investor’s MSCI World ETF holding is 60% exposed to the pound: US dollar exchange rate. Equities priced in pounds make up 5.8% of the index, so your overall currency risk is 94%. As you can see, 8% of the currency risk is against the yen, while there’s 0.3% exposure to the Norwegian krone.

Currency weightings - MSCI World ETF

Currency weightings - MSCI World ETF
   U.S. Dollar (USD)
   Euro (EUR)
   Japanese Yen (JPY)
   British Pounds (GBP)
   Canadian Dollar (CAD)
   Swiss Franc (CHF)
   Australien Dollar (AUD)
   Hongkong Dollar (HKD)
   Swedish Krone (SEK)
   Danish Krone (DKK)
   Singapore Dollar (SGD)
   Norway Krone (NOK)
   New Shekel (NIS)
   New Zealand Dollar (NZD)
Source: iShares Core MSCI World UCITS ETF; as of 09/06/2021

ETF currency risk: your options

  • Avoid: Increase your asset allocation to your own currency area, i.e. invest in UK equities, property and bonds if you settle your bills in pounds. The obvious downside is that you’ll be less diversified, especially as the FTSE 100 and FTSE All-Share are heavily skewed to three sectors: financials, energy and consumer staples. Both indices are also dominated by global large caps like HSBC and Royal Dutch Shell that earn most of their revenue abroad. Around 75% of FTSE 100 firms’ earnings come from overseas, which means that they too are heavily exposed to currency risk. When the pound falls, those foreign earnings are worth more in pounds, boost the share price of the major players in the index, and boost your FTSE 100 or FTSE All-Share ETF. Again, the same is true in reverse and also true for the dividends you receive. If you want to engineer more home bias in your portfolio, then the firms tracked by FTSE 250 ETFs are much more reliant on UK based earnings.
  • Diversify: Splitting your assets between different assets and markets reduces your investment risk. The same applies to foreign currencies, as discussed above. Intriguingly, you can also benefit from your exposure to safe-haven currencies like the dollar and euro. The dollar especially has exhibited a negative correlation with world equity prices historically. Because the dollar is the world’s reserve currency and is used as a store of value by corporations and ultra-high-net-worth individuals, its rising value can cushion the blow of falling equities for a non-US investor. Your risk also changes if you split your residence between different currency areas. If you live in the UK for part of the year and France, say, for the rest of the year (or think you will) then you should hold assets in pounds and euros, so you can pay your bills in both countries without concern for currency risk. Diversification is also the answer if you fear the long-term decline of the pound - overseas assets are an ideal hedge against that scenario.
  • Long-term investment: Financial theory and evidence indicates that stock market returns are driven by a country’s economic performance over the long term. Therefore, our ETF portfolios offer long-term investment strategies that enable you to harness GDP growth opportunities across the entire world as opposed to the futile task of trying to predict short-term market fluctuations.

ETF currencies: cutting through the confusion

Many people are exposed to currency risk without realising it because there’s a profusion of confusion when it comes to the currency labels applied for funds. Let’s clear that up:

1. Underlying currency


2. Fund currency

This term is responsible for much of the confusion surrounding ETF currencies. The terms base currency or denominated currency are also often used. Crucially, these terms refer to the currency that an ETF reports in, not necessarily the currencies that the underlying securities trade-in. The ETF reports its Net Asset Value in the fund currency and distributes income in that currency too. Your broker will convert your income into pounds, but will likely charge you an exchange rate fee for doing so. The fund currency is generally based on the currency used for the underlying index. The index currency is usually the same as the currency in which most of the index’s securities are traded.
justETF tip: The fund currency is displayed on each ETF profile at justETF.

3. Trading currency


4. Currency hedging

justETF tip: You can easily find GBP hedged ETFs by using our ETF search

Why do exchange rates fluctuate?

Exchange rates mainly result from the forces of supply and demand for national currencies. For example, the currency of a leading export nation is likely to strengthen over time because of the high demand for its goods, all things being equal. The currency markets also influence exchange rates. Currency traders move swiftly to exploit any arbitrage opportunities. The carry trade is a famous example - traders borrow in a low-interest rate currency and buy into a high-interest rate currency. The aim is to profit from the interest rate differential. However, arbitrage opportunities are usually fleeting and high risk, as exchange rates move to reset the market equilibrium between pairs of currencies.

Naturally, central banks influence the value of their national currency through monetary policy. You can see this playing out as countries recover from the Global Financial Crisis at different rates. The US-led the Developed economies out of the crisis and has been able to raise interest rates faster than the Bank of England or the European Central Bank. Hence, the US dollar has strengthened against the pound in recent years, benefitting UK investors who held significant US assets. Other countries are known for playing a more active role in their exchange rate. China, for example, is thought to manage the rise of the Yuan to preserve the competitiveness of its export sector.

The main takeaway is to recognise that the currency markets are among the most efficient and competitive in the world. Small investors have neither the speed nor information to prosper for long in this space. Therefore, it’s best to adopt a currency risk position on a strategic level that aligns with your long-term goals.
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