The Pound and How to Manage Currency Volatility

Will the collapse of sterling in the last few weeks, a lot of people have asked how this currency volatility and general currency fluctuations will effect their investments. So this week, we have a guest post from Dimensional Fund Advisors , in which they explain currency fluctuations, how hedging works and when you need to use it.

Since Britain voted to leave the European Union, the pound has slumped to a five-year low against the euro and a 30-year low against the US dollar. Currencies have historically been volatile and unpredictable, but this unpredictability need not cause concern to investors with global assets.

It is hard to quantify the complex effect of currency movements. For example, a weaker pound may be advantageous for UK exporters but bad for foreign companies selling goods in the UK. All else being equal, sterling investors with unhedged assets overseas are likely to have gained, while European investors with UK unhedged assets may have lost out.

Academic evidence suggests that currency movements are difficult to predict in the short- to medium-term in a manner that is relevant for making investment decisions. Currencies differ from shares and bonds because they do not produce interest or profits; therefore, they do not have an expected long-term positive return. It is possible to profit from currency trading, but trying to do so is highly speculative and, on average, returns are close to zero.

We do not attempt to predict currency movements, but, because we value the benefits of diversification and increased opportunity that global bonds and shares offer, we pay close attention to the way currencies affect the performance and characteristics of your portfolio.

Some investors seek to reduce volatility by hedging their currency exposure—like when the bureau de change offers to buy back your unused currency at the same rate it sold that currency to you. We think that hedging depends on the asset class and the aim of the strategy. In global equities, hedging foreign currencies tends not to reduce return volatility by a significant amount. Equities are more volatile than currencies, so the volatility of an unhedged global equity portfolio is, on average, dominated by the volatility of the underlying equities, not the currency movements.

In global fixed income, hedging currencies is an effective way to reduce return volatility because currency returns are more volatile than investment-grade fixed income returns. If the currency exposure is unhedged, the currency will be mostly responsible for the volatility in a fixed income portfolio.

We generally hedge the currency exposure of our global fixed income strategies with the goal of reducing volatility. But we do not see the same volatility reduction benefit for our multicountry equity strategies, and in most cases, do not hedge currency exposure in these strategies.

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