Time for currency hedging for sterling investors?

The low pound has often been a disadvantage for investors, reducing the international value of UK-oriented investments that tend to dominate UK retail portfolios.

But every cloud has a silver lining, most notably the sharp drop in sterling. A depreciating currency can be a boon, especially for investors with large equity holdings overseas.

If someone in the UK had bought US stocks in 1980, they would have benefited from the strong performance of US stocks of 11.1% per year, but the devaluation of the currency would have pushed their yield up to 13.1% when he converted his US shares back to sterling this year. . A pound invested in US stocks in 1980 was worth £179 in 2022, but a dollar invested in 1980 was “only” worth $83 today.

Older savers aren’t the only ones to thank the weaker currency for the performance of US equities. The sell-off in US equities this year is not nearly as painful for UK investors. While the S&P 500 is in a dollar bear market (down more than 20 percent), it’s not even in a correction (down more than 10 percent) for sterling investors. Those who cautiously hedged currency movements early in the year would have lost out and suffered the same losses as US investors.

Why has the pound weakened so much against the US dollar? In the long term, the currencies converge very gradually towards an equal purchasing power. The Big Mac index maintained by The Economist illustrates this well. If a Big Mac costs £3 in London and $5 in New York, a fair exchange rate (based on buying parity for hamburgers) would be 1.67, because £3 would convert to $5. If you do the purchasing power calculation correctly, taking into account a basket of equivalent goods and services on both sides of the pond, the fair rate in 2021 came out at 1.44. This estimate, which is based on “purchasing power parity” (PPP), is now 30% higher than the exchange rate for the sterling dollar.

PPP estimates for exchange rates tend to vary slowly as purchasing power fluctuates gradually with rates of inflation and these tend to be similar across developed countries. For example, the Pound-Dollar PPP exchange rate has been between 1.38 and 1.46 over the last 30 years, while the Pound Sterling has fluctuated wildly from 1.13 to 2.07 during this period. .

Other factors can influence the currency in the short term. Interest rates matter, which is why the last time the dollar approached parity with the pound was during US Federal Reserve Chairman Paul Volcker’s inflation fight in early 1980s, when the US policy rate exceeded 19%.

Currencies with higher interest rates tend to appreciate relative to those with lower interest rates. Every crisis seems to weaken the British pound and it usually fails to recover to its previous level after each one. In 2008-2009, during the global financial crisis, the pound sterling fell by 30% against the dollar. Brexit also weakened the pound sterling by around 30%. And, just when it looked like the Brexit weakening was about to reverse, we entered another era of dollar strength as the Federal Reserve raised rates more aggressively than other central banks. , including the Bank of England. The global sell-off in equities also weighed on the British pound which falls into the risk currency camp unlike the US dollar which is seen as a safe haven. The coup de grace has recently been the destabilizing effects of the British mini-budget.

Some of the factors that have been dragging the pound down recently will fade. For example, the Fed’s relatively high policy rate of 3-3.25% will drop while the Bank of England, whose discount rate is currently 2.25%, will catch up. The UK yield curve is already roughly in line with that of the US with a yield of around 4% on 1-30 year government bonds (gilts).

Although politics is unpredictable, it seems likely that the British government, whatever its composition, will adhere more to economic orthodoxy and that the current onslaught of crises will ease. Eventually, the fear gripping the markets will subside as equity markets recover. If these factors subside, many wonder if the British pound will reverse its losses and start to recover to a value above 1.40, as suggested by the PPP.

If risk appetite picks up and global equities return to their usual upward trajectory, UK investors could miss out. Indeed, many of the factors that are weakening the pound are also those that are holding back global stock markets. If the two rise together, and given the dominance of US equities which make up more than 60% of global markets, then the blessing of additional yield from sterling weakness against the dollar will turn into a curse.

So should UK investors rush in and hedge their equity holdings? It’s now quite easy by switching to global and US equity funds hedged to sterling. The additional charges for currency hedging are generally small.

The choice really comes down to whether you think the pound will eventually reverse the 50-year trend and start appreciating against the dollar. If so, it would make sense to hedge against this outcome with sterling hedge funds. Some institutional investors take a split approach where if you are 50% confident that the pound will strengthen, you will hedge half of your global and US stocks and leave the rest unhedged.

Not all platforms offer sterling-hedged equity funds: the Vanguard UK platform, where I have investments, does not. But investors who can access such options should consider at least partially hedging against a possible rally in a weak currency.

Ramin Nakisa is co-founder of Pensioncraft

Robert D. Coleman