Currency Risk in an International Investment Portfolio: What You Need to Know

Currency exposure is one of the most underappreciated risks in investment portfolios — and one of the most complex to manage for internationally mobile individuals. A UK investor who held a US equity index fund in 2022 saw sterling fall sharply against the dollar, boosting the fund's sterling return well beyond the underlying dollar return. The same investor in a period of sterling strength would have seen the reverse: a fund that performed well in dollar terms that looked mediocre in sterling.

For expats, retirees abroad, and internationally mobile professionals with income in one currency, assets in several, and expenses in a third, currency management is not an optional add-on. It is central to whether your wealth plan actually works.

How Currency Exposure Affects Returns

The total return on an overseas investment in your home currency has two components: the return in the local currency of the asset, and the change in the exchange rate between that currency and your home currency.

If you hold a Japanese equity fund and Japanese equities rise 10 per cent in yen terms, but the yen falls 8 per cent against sterling, your sterling return is approximately 2 per cent — not 10 per cent. Conversely, if the yen rises against sterling, your sterling return can significantly exceed the local return.

Over long periods, currency movements have historically been a source of both additional return (when your currency weakens relative to the assets you hold) and additional volatility (the return is less predictable than an unhedged domestic investment). Whether currency exposure is beneficial or harmful depends on timing and direction — neither of which can be reliably predicted.

Currency Denomination vs Underlying Economic Exposure

A critical distinction: a fund denominated in sterling does not necessarily have sterling economic exposure. A FTSE 100 tracker fund is priced in sterling, but the underlying companies earn most of their revenues in dollars, euros, and other currencies. As a result, it provides significant natural foreign currency exposure even to sterling-based investors.

Similarly, a dollar-denominated fund may hold assets whose underlying value is tied to the Indian rupee, Brazilian real, or other currencies. Denomination is not economic exposure.

Understanding the true currency exposures within a portfolio requires looking through the fund denomination to the underlying asset composition. This is particularly relevant for multi-asset portfolios where fund-of-funds structures can obscure the actual currency mix.

Natural Hedges

A natural hedge exists when a currency exposure on the asset side of your balance sheet is matched by a currency liability or expense on the other side.

Common examples for internationally mobile individuals:

• Sterling mortgage vs sterling property: if you own UK property with a sterling mortgage, the property asset and the mortgage liability are both sterling. A change in sterling vs your base currency affects both roughly equally, reducing the net currency risk.
• Dollar income vs dollar expenses: if your employer pays you in USD and you live in the UAE (where the dirham is pegged to the dollar), your living expenses are effectively dollar-denominated. Dollar income and dollar expenses cancel out.
• Multi-currency spending: if your lifestyle genuinely splits spending across several countries and currencies, a multi-currency portfolio with corresponding currency exposure may be a natural hedge in itself.

Identifying and mapping natural hedges is the first step in currency management — you may have more natural protection than you think.

Hedging Costs and Mechanics

Synthetic currency hedging involves using financial instruments — typically forward exchange contracts or currency swaps — to fix the exchange rate at which you will convert a future cash flow. It is a tool available to institutional investors and, through fund structures, to retail investors.

The cost of hedging depends on the interest rate differential between the two currencies. If sterling interest rates are higher than dollar rates, a sterling investor hedging dollar exposure will pay a positive hedging cost (the cost is embedded in the forward rate). If rates move in the other direction, hedging may actually be economically neutral or beneficial.

Hedged share classes of funds provide currency hedging automatically within the fund structure. A sterling-hedged share class of a global equity fund delivers returns closer to the underlying local-currency return by removing most of the sterling/other currency exchange rate movement. The cost of this hedging is deducted from returns.

The key question is not whether to hedge, but which currency exposures are worth the cost of hedging and which are best left unhedged.

Currency Overlay Strategies

For larger portfolios, a currency overlay — a separately managed currency hedging programme sitting above the underlying investment portfolio — provides more sophisticated control. An overlay manager can:

• Hedge specific currency pairs selectively, based on the investor's base currency and liability currency
• Vary hedge ratios (the proportion of exposure that is hedged) in response to market conditions
• Use options as well as forwards, providing downside protection while retaining some upside from favourable currency moves

Currency overlay is typically economic only for portfolios above £5 million to £10 million, where the cost of the overlay (manager fees plus transaction costs) is outweighed by the reduction in currency-driven return volatility.

Living Expense Matching

One of the most practical currency management strategies for internationally mobile individuals is matching your investment currency allocation to your expected future spending currency.

If you plan to retire in Spain and spend euros, a retirement portfolio heavily weighted to sterling assets carries significant currency risk — a sustained sterling decline would erode the real value of your retirement income in euro terms. Gradually shifting the retirement portfolio towards euro-denominated assets reduces that risk.

This is particularly relevant as individuals approach or enter retirement. The sequence of returns risk in drawdown (poor returns early in retirement having a disproportionate impact) is compounded by currency risk. Building a retirement income strategy that matches the currency of assets to the currency of expenses is sound planning.

Rebalancing Across Currencies

Portfolio rebalancing — buying and selling assets to maintain target allocations — in a multi-currency portfolio creates currency transaction costs at every rebalance. Over time, if these are not managed carefully, the cumulative cost of currency exchange can be material.

Strategies to reduce this cost include:

• Directing new contributions or dividend income into underweight positions before selling existing holdings
• Using multi-currency accounts that allow positions to be held in their natural currency without automatic conversion
• Batch rebalancing less frequently, accepting some tracking error against target allocations in exchange for lower transaction costs
• Using currency-flexible platforms that allow trading across currencies in a single account

Which Currency Risks to Hedge, and Which to Accept

A practical framework for deciding:

Hedge if:

• The currency exposure is large relative to your wealth
• The currency of the asset does not match the currency of any corresponding liability or expense
• You have a definite near-term liability in a specific currency (buying a property, paying school fees) and cannot afford adverse currency movements
• The hedging cost is modest relative to the risk being mitigated

Accept (leave unhedged) if:

• The exposure represents a natural hedge against a corresponding liability or expense
• The hedging cost is high relative to expected return
• The currency exposure is to a broadly correlated currency where movements are likely to be small
• The time horizon is very long and short-term volatility is acceptable

There is no single right answer. The optimal strategy depends on your specific circumstances, base currency, spending patterns, and attitude to risk.

Investments can fall as well as rise in value. Currency movements can result in gains or losses. The costs of hedging strategies may reduce returns. Professional advice should be sought before implementing currency management strategies.

How Global Investments Can Help

Currency management is one of the most technically complex aspects of wealth management for internationally mobile individuals. Global Investments advises clients on building portfolios that reflect their true currency exposures and liability profile — from identifying natural hedges to implementing currency overlay strategies for larger portfolios.

If currency exposure is a concern — whether because of a significant offshore asset base, international income streams, or planned future spending in a specific currency — we would welcome the opportunity to discuss how we can help. Contact us for a confidential conversation.