Two of the strongest performing markets in recent years have been Europe ex UK and Japan. Analysis by FE Trustnet suggests that the average open-ended fund in each of these sectors has returned 65.6% and 53.8% respectively over the last 36 months, but it could have been even better.
Most of these funds do not hedge their currency exposure, which means that UK-based investors will be affected by the movement in the relevant exchange rate. Over the last 3 years the euro has fallen from 80.5 pence to 73 pence, so a euro denominated investment like a European fund would have lost almost 10% even if the underlying holdings had remained at the same value.
It is a similar situation for UK investors with a Japanese fund. During the course of the previous 36 months the yen has depreciated from 0.81 pence to 0.52 pence. This represents a loss on the currency exposure of 36%.
The main reason for the strength of the European and Japanese stock markets and for the decline in their currencies is the policy of quantitative easing. Both central banks have embarked on a massive programme of monetary stimulus, which boosts the value of local assets while weakening their exchange rates.
I know that these are unusual circumstances, but it raises the question of whether it is worth using a fund that hedges the currency risk. It is an issue that has recently been examined by Deutsche Asset & Wealth Management.
According to their analysis, currency hedging would often have led to a significant reduction in overall portfolio volatility for a global investor, especially for short- to medium-term investment holding periods.
The overall performance difference between hedged and unhedged indices for a euro-based investor has been small over the last 13 years, but on a year-by-year basis the currency effect has outweighed equity market returns in more than half of the calendar years (7 out of the last 13).
Their study shows that the maximum one year loss on the foreign exchanges for a UK-based investor during the last 16 years would have been 16.2% when exposed to the US dollar, 15.3% versus the euro, 22% against the Japanese yen and 23.5% versus the Swiss Franc.
A currency hedge will eliminate any gains in the same way as it would any losses. The hedge also involves an additional expense, both in terms of the transaction costs and the potential cost of carry based on the interest rate differential between the two currencies, so it is not a straightforward decision.
Looking back, none of the top performing actively managed open-ended European funds were fully currency hedged, but that was not the case in Japan, where the second placed fund as measured over the last 3 years was Lindsell Train Japanese Equity hedged.
It certainly seems to be more of an issue for Japanese funds as many of the most popular options have separate hedged and unhedged shares classes. For example, the unhedged version of Legg Mason Japan Equity has risen 17% in the last 6 months, whereas the hedged equivalent is up 19%. Some of the other funds have the scope to hedge, but leave it up to the manager whether or not to do so.
Longer term investors are probably best advised to use an unhedged fund as it would be impossible to take a sensible view on where the exchange rates will be in 5 or 10 years’ time, but those who are making more of a tactical asset allocation decision should give it a lot more thought, especially while central bank polices are driving the markets.