Why the pound’s decline can be a shrewd investor’s gain

An underappreciated driver of investment performance is the impact of currency changes, especially now that more and more investors are opting for global or US funds, rather than sticking with UK-listed assets.

A typical global developed world tracker fund now has around 70% in US equities and just 3.5% in UK equities.

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When owning assets that are priced in a foreign currency, if the value of the other currency rises versus pounds sterling, that means the value of your investment in pounds rises. The reverse is also true – a rising pound would negatively affect the value of foreign assets when they are converted back into pounds.

This means that the fall in the pound’s value versus the dollar since September 2024 has boosted the value of many investments.

One pound now buys $1.23 dollars, 8% less than the $1.34 it bought four months ago.

Pound drops against the dollar

Source: Refinitiv, 23 January 2025.

The pound has been falling, even as gilt yields have risen, due to a lack of confidence in the UK government.

This is because inflation has been ticking higher, hitting 2.3% in October and 2.6% in November. There are also fears of stagflation – low or no growth, or recession, combined with rising inflation. Stagflation would be very bad news for the economy.

Now, higher borrowing costs could lead to higher taxes or spending cuts, or both, to balance the budget. This could undermine economic growth and damage confidence further in the UK. 

You would expect rising gilt yields to be accompanied by a rising pound, but that is not the case. 

Mike Riddell, portfolio manager, Fidelity International, says: “Normally, currencies are driven by interest rate differentials, where higher gilt yields relative to other countries would be expected to push the pound stronger.

“The combination of a weaker pound and higher relative gilt yields has eerie echoes of August-September 2022, and if this continues, could potentially be evidence of a buyers’ strike or capital flight.”

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But rather than just a short-term drop in the pound’s value, there could be a longer-term trend of devaluation versus the dollar if the UK continues to battle inflation and low or non-existent economic growth. On the other hand, the pound could recover.

Dzmitry Lipski, head of funds research at interactive investor, says that investors need to consider currency exposure as one of the key elements of their portfolio.

However, he cautions that: “History shows that currencies can be very volatile, and trying to predict their direction could prove a risky strategy for retail investors as no single market can benefit from currency movements in all economic conditions.

“It’s important to remember that the best way to grow your investments is by investing for the long term in a well-diversified portfolio of different asset classes and geographies to achieve the right mix of risk and return.”

Here are some ideas about how to navigate currency swings.

If you think the pound will keep falling...

Then investors can benefit by owning assets denominated in other currencies. It does not matter if they do this by owning assets traded in dollars, such as US shares, or with assets traded in pounds that give exposure to dollars, such as exchange-traded funds or investment trusts.

So long as there is no “hedging” in the fund, then the currency changes will impact returns.

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If you think the pound will recover...

Then owning the “hedged” share classes of funds will protect you from currency moves. For a small extra fee, fund managers will use derivatives to cancel out the impact of currency changes to try and replicate the exact performance of the underlying index when converted back into pounds.

Hedging currency exposure is tricky for DIY investors themselves, so it’s far simpler and cheaper to pay a fee for a fund manager to do this for you.

Owning a hedged fund share class can have a large impact on returns, particularly when investing in emerging markets, where currency can be very volatile and often declines significantly in value relative to the pound.

A rising pound could be good news for smaller and mid-sized UK companies, as imports become cheaper but these companies tend to sell into the domestic market. On the other hand, larger companies tend to export more, so a weaker currency can lead to more international sales.

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Then it’s probably best to not pay too much attention to currency. Terry Smith, the manager of Fundsmith Equity, does not hedge his currency exposure.

In the “Owners’ Manual” for his fund, he says: “Our policy is not to hedge our currency exposure. There are several reasons for this. One is that we do not purport to be any good at currency trading. It has a cost, which is often rather more than it appears when you are being sold the hedge. In addition, you cannot know what any individual company’s currency exposure is without knowing what hedging, if any, it has conducted in its own treasury operations.”

Smith adds that you cannot permanently hedge a portfolio or a company against movements in any commodity with a price which fluctuates.

“Many of the companies we invest in generate revenues in the same currencies as they incur most of their costs. Therefore, their exposure to currency fluctuations is largely a matter of translation of their profits,” Smith says.

How have popular hedged and unhegded funds performed?

Source: FE FundInfo, 27 January 2025. Past performance is not a guide to future performance.