Why investing internationally could improve your investment returns
A slide in the value of sterling against the dollar and the euro over the past 18 months has brought into sharp focus how important exchange rates are to investors. Far from being a secondary concern, we’ve seen a period when succumbing to ‘home bias’ and ignoring currency exposure, can damage investment returns.
The UK’s decision to leave the European Union triggered a devaluation of the pound against major currencies in the summer of 2016. But a sustained weakening of sterling goes back way before that. So it’s now much harder to justify the argument that exchange rates are hard to predict and less important than underlying share prices.
What we’ve seen has highlighted just how important foreign market diversification can be. Faced with a weaker pound (and the possibility of it falling further in the coming months) investors with all-sterling portfolios are at risk of needless underperformance. And those who are comfortable with their investment performance, may actually find that they aren’t doing as well as they think.
Exchange rate moves can ruin your investments
Since the EU referendum, sterling has slipped by 12 percent against the dollar and 15 percent against the euro. But the weakness actually started long before that. Over 24 months, the pound is down by 13.6 percent against the dollar and a whacking 21.9 percent against the euro. In fact, the pound has been falling against the dollar since the middle of 2014.
For most investors, this has generally led to questions about how different companies might be affected. But a more pertinent question should focus on how to avoid losing out to this negative exchange rate trend. Some companies can’t avoid the impact of varying exchange rates, but investors can — by diversifying their exposure across foreign markets.
How foreign exposure can work in your favour
The immediate impact of the falling value of sterling — ignoring for a moment how equity prices have moved over the past two years — is that US and European assets held by UK investors are now worth considerably more. Without doing anything, the currency effect has had a huge impact.
Let’s take an example. Say you bought 10 shares in Amazon at $647 each back in November 2015. At the time, your $6,470 investment would equate to around £4,256. Let’s assume Amazon’s stock price didn’t move between then and now. On currency movements alone, that holding would be worth £4,938 — a £682 gain.
But, of course, Amazon’s share price has been rising in the past two years. Added together, that surging stock price and the forex kicker has resulted in a gain of over 100 percent.
It works both ways
In many ways, highlighting the benefits of foreign exposure is just one side of the exchange rate coin. The counter argument is that a weaker pound has been very beneficial for at least some UK investors. Markets have been rising since the 2016 devaluation — and some commentators believe that weaker sterling has played a part in that.
Equally, the FTSE 350 is in itself a useful hedge for exchange rates. A big chunk of revenues across those stocks derive from foreign territories — they’re earning and reporting in dollars and euros, which means that investors get the exposure. So there can be some natural hedging in an all-UK portfolio. But it really does depend on the diversification in the portfolio.
You’re doing less well than you thought you were
It’s easy to look at the performance of the UK market over the past two years and feel reasonably satisfied. But it’s possible that when looking at that performance in dollar terms, many investors simply aren’t doing as well as they thought.
If you study the performance of FTSE companies in dollar terms, it’s clear that the market has been under pressure in recent years. Take a look at the performance of the dollar-denominated FTSE 100 and you’ll see an uptick over the past year, but on a three year view the market has returned just 6.6 percent to the end of October 2017. It once again illustrates how ignoring exchange rates can be misleading.
Why investors should diversify…
It’s a well known phenomenon that investors tend to be prone to ‘home bias’, and stick to what they know — and where they know. Exchange rates are not normally a major consideration for many investors, but recent trends show why they should be. It’s hard to argue that events of the of the past two years offer anything other than a big lesson that spreading currency risk by investing overseas is a good idea.
So if you believe the pound will fall further, or that currency exchange rates are too much of a headwind, then getting more foreign diversification is an answer.
Originally published at www.stockopedia.com.
Disclaimer: This content should be used for educational & informational purposes only. We do not provide investment advice, recommendations or views as to whether an investment or strategy is suited to the investment needs of a specific individual. You should make your own decisions and seek independent professional advice before doing so. Remember: Shares can go down as well as up. Past performance is not a guide to future performance & investors may not get back the amount invested.
