Currency: Winning the zero-sum game
It is often said that foreign exchange markets are a zero-sum game - for one currency to fall, another must surely rise.
If you're buying an asset in your home currency, you're buying into one risk. If you're buying a foreign asset, you're buying into two risks - one related to the investment, one related to the currency exposure.
If you run a business, particularly one that deals internationally, you (or your FD) will know the risks of large currency movements and how it can impact your overall profitability. Consider that, in 2013, the daily value of world goods trade was $52bn. The daily foreign exchange turnover was a thousand times larger at $5.3tn. So, in one sense it is a zero-sum game, but in another there are clearly advantages to being leveraged.
The same principle applies to your individual investments and wealth. The majority of UK investors have their day to day liabilities in Sterling and a significant proportion of their wealth in UK assets. However, Sterling has depreciated by 19% against the Euro and US Dollar in the last 12 months, having a dramatic impact on the value of that wealth.
A weak currency is the sign of a weak economy, and a weak economy leads to a weak nation. - Ross Perot
So is there any way around this zero-sum game?
When it comes to longer term investments, if this is in individual stocks and shares (or a "segregated" portfolio), it is a pretty binary choice regarding currency, when investing outside the UK. Generally they will have a choice of a fund or stock that is priced in sterling, or one that is priced in the currency of the market to which they want to gain exposure. And usually the choice has to be made at the outset. This creates significant issues.
The investor has to be right both in the investment decision and in the currency decision to fully benefit from the trade. To make an informed decision, they must be sufficiently aware of both sides of that trade. Availability and taxation implications mean it is rare to switch between units in sterling and the base currency. Therefore once the decision is made it is made for good.
Using a unitised strategy (wrapping the underlying investments in a fund) enables us to separate out the currency risk from the investment risk and keep reviewing that currency position throughout the life of the investment. This means within the unitised structure it is possible to manage the currency exposure using futures, which enable us to consider not only what markets to invest into, but also whether the underlying currency looks good value or not against sterling. This is important at the outset, but fundamental over the life of an investment position.
Japan in recent years is a prime example of the advantages that this can reap. If you had invested in the Japanese stock market in 2014 and held shares in sterling, you would have made 18%, as opposed to 10% if they were held in yen. Using a unitisation approach, you can benefit from this, whereas if you invested direct into individual holdings, you could not.
It is not always possible to get currency decisions right, but separating the currency decision from the investment decision, means that overall, an investor has a better chance at the zero-sum game.