Currency effects can have a big bearing on asset values, but the good news is that this can be a valuable source of diversification and globally orientated investment managers will factor currency strength, or weakness, into overall portfolio construction.
A move in the pound versus other global currencies can have a big impact on the value of an investment holding. It is not uncommon for currency movements to have a more significant bearing on the price of an investment than fundamental changes in the underlying value of the assets in the local currency. In that sense, currency movements represent a behind the scenes influence, but one that can have a big impact on returns.
2018 provided a really good example of how investors from the UK holding foreign assets could actually benefit from the relative weakness in sterling. This is neatly exhibited in the performance delivered by the US stock market in 2018 in sterling terms. Despite a summer high, the S&P 500 index slumped rapidly and shrank back such that by the mid-autumn it had given up those gains for the year. By the close of the year it had fallen circa 5 per cent over 2018 from start to finish.
Performance of S&P 500 in sterling during 2018
Source: FE Analytics
For UK-domiciled holders, however, currency effects meant the impact was not felt as sharply. Because sterling weakened throughout the year in contrast to strength in the dollar, that insulated UK investors from those losses and in sterling terms the index actually delivered a small total return.
Turning to what is going on right now, we’ve seen the pound react to the various news items and stories emanating from Westminster. That has seen UK investors with holdings in the FTSE 100 actually benefit on the whole because of the global nature of the index. A UK-listed company selling goods or services in the US, for instance, needed to make around $14.5m of sales to generate £10m of revenues in summer 2016.
Today, they only need around $13m of sales in the US to generate the exact same revenue in sterling terms. Just for being listed in the UK the firm can, in effect, suffer a circa 10 per cent drop in sales and yet stand still in equivalent terms once the revenues are translated back into their domestic currency. That currency impact has actually benefited large-cap firms reporting profits in pounds but earning revenues overseas.
Performance of sterling in US dollar since EU referendum
Source: FE Analytics
This all helps to explain why investors in foreign domiciled assets need to consider the impact of currency effects. Globally diversified portfolio managers will take stock of currency impacts as part of their holistic assessment of the properties and characteristics of an asset. Portfolio managers considering their aggregate position will be looking at currency exposures and aiming to deliver a real return in their home currency, so will factor in foreign exchange risk as part of portfolio construction.
Crucially, currency movements show why a globally balanced portfolio is such a critical part of building real diversification. Where your domestic market suffers, potentially dragging down asset prices, exposure to foreign currency can be a valuable form of diversification away from woes in an investor’s local region.
Sacha Chorley is portfolio manager at Quilter Investors. All views are his own and should not be taken as investment advice.