Home bias and currency risk

SlaveToMyCats

This applies to my ISA but also to my pension.



Ideally I want to have realatively low exposure to UK and don't want my portfolio to be overly biased. But of course the currency may strengthen significantly (maybe 20%) over the next year or more which will be very poor for such a portfolio. If I could wave a magic wand I'd have an ex UK portfolio hedged against GBP movements.



Is there a sensible and 'mainstream' way I can have this and are there any major pension funds, robo advisors etc which do this for me?

pip895

You could look at - iShares III plc (IWDG) Core MSCI World UCITS ETF It doesn't explicitly exclude the UK but its a small percentage.

Prism

In a year currency movement might be important but in 10 years it likely won't. Who knows where it will be then. Its expensive to hedge currency and over the long run it typically underperforms

bowlhead99

SlaveToMyCats wrote: »

Ideally I want to have realatively low exposure to UK and don't want my portfolio to be overly biased. But of course the currency may strengthen significantly (maybe 20%) over the next year or more which will be very poor for such a portfolio. If I could wave a magic wand I'd have an ex UK portfolio hedged against GBP movements.

Is there a sensible and 'mainstream' way I can have this and are there any major pension funds, robo advisors etc which do this for me?

It's not a popular option because you are essentially saying you want low UK allocation (presumably don't trust UK markets and economy to do well, even though share prices are relatively low compared to p/e ratios elsewhere in the developed world) ; but you also don't trust UK economy /not/ to do well, so you fear sterling strengthening significantly.

You could buy the iShares MSCI World GBP Hedged UCITS ETF (Acc) from most UK stockbrokers or investment platforms that deal in UK-listed ETFs, ticker IGWD. It hedges the international assets monthly to GBP using forward contracts, though will of course be an imperfect hedge and its running costs will be higher than an unhedged version. Not just the OCF compared to the cheapest more popular unhedged products, but the hidden implicit costs of funding the hedge through rolling forward contracts.

(https://www.ishares.com/uk/individual/en/products/251892/ishares-msci-world-gbp-hedged-ucits-etf)

Of course, the flipside of the 'benefit' of hedging is that if/when the assets fall in value and sterling weakens further which would have offset the fall - or even if the international assets stay at the same prices in their local currency while sterling weakens - the value of your investment won't benefit from that weakening. Unlike the pension and ISA assets of your fellow countrymen who didn't hedge.

Alternatively, HSBC's Global Strategy multi-asset funds of funds series have some partial hedging of their overseas equities and more comprehensive hedging of their overseas bonds, to help them stay within their risk / volatility targets. But the hedging there is not as heavy as on the iShares ETF mentioned.

A number of hedged share classes exist for internationally-invested ETFs if you were looking to replace holdings for individual countries. Here's a factsheet for the iShares Core S&P500 GBP Hedged (GSPX) . They also have a slightly more expensive but longer-running standalone GBP hedged product for the S&P (IGUS). Of the two S&P500 hedged offerings from iShares, GSPX would seem to be the one to get, due to lower costs and greater size and liquidity, as well as a better performance over the last 12 months. Though the performance difference may just be a measurement difference, I haven't checked; and GSPX is a dividend distributing rather than accumulating product.

It can be seen by comparison with the 'real' underlying index that the returns are compromised when hedging. For example the unhedged benchmark S&P500 index gave a 1 year return to end of November of 15.41%. The hedged version GSPX gave only 13.15%, which is 2% worse even after adjusting for OCF, so in that case you might have been better to take the US result and the small FX translation loss. The rates only moved from $1.28 to $1.29 during the period, which is less of a drag than the implicit cost of hedging. Really, hedged products are acknowledged as being more expensive but provide some protection in case of a much bigger movement than we observed over the year to November.

Disclaimer, I have a small holding of GSPX in my pension - only about a percent or two of my portfolio, acquired pre-election, just for fun. It was quite nice watching it not fall with my other dollar-influenced holdings while the pound rallied from the high 1.20s to 1.35 over the course of a few trading sessions, but the fx rate strengthening didn't persist for long and then reversed.

SlaveToMyCats

bowlhead99 wrote: »

It's not a popular option because you are essentially saying you want low UK allocation (presumably don't trust UK markets and economy to do well, even though share prices are relatively low compared to p/e ratios elsewhere in the developed world) ; but you also don't trust UK economy /not/ to do well, so you fear sterling strengthening significantly.

That's a fair summary.


I had not accounted for the cost of hedging in my thought process, and indeed that explains to me why it isn't a more popular option. Thanks for your analysis on the costs involved, it is a real eye opener for me.



I will definitely take a look at HSBC Global Strategy, I had actually been considering the dynamic fund for a fairly large chunk of my SIPP.


Thanks!

bowlhead99

SlaveToMyCats wrote: »

I will definitely take a look at HSBC Global Strategy, I had actually been considering the dynamic fund for a fairly large chunk of my SIPP.

They don't say exactly how much they hedge the international equities, only that the target asset allocation includes a partial hedge and you can see from the annual or semi-annual reports that they do hold some derivatives with which to do that. It does not seem to be a bad fund and fits in with your ethos of generally using indexes rather than active funds to select the underlying assets.

As full hedging causes you to give up the currency gains that other UK pension investors are making when the economy and sterling weakens, it would perhaps be a strange choice to accept that sacrifice if you had a negative outlook on the UK.

In the other thread on which you participated, you said that "the stark reality is that markets are very efficient and you have virtually no chance of outperforming them". Whereas here, you believe you can get a better result for yourself by overriding the raw market returns and instead skewing the result through derivatives. This is a form of active portfolio management, which you had implied was worthless because professional managers couldn't reliably do it, despite being supported by analysts, market information etc.

I expect you allow yourself this cognitive dissonance by taking a narrowly defined view of 'performance' - that active management is useless for improving 'performance' but that it might after all be useful for improving volatility, or for reducing downside risk from certain short-term market conditions at the expense of potential gain, etc. But clearly the volatility of a set of holdings across market conditions is one aspect of performance. For example, a manager may actively decide to hold less than the market weight of tech stocks ahead of the bursting of the dot-com bubble in 2000, or avoid bank stocks in 2007. Missing prospective gains in pursuit of lower volatility and downside protection. in a collapse.

If you buy the MSCI world market index, you get over 10% in Apple, Microsoft, Google, Facebook, and under 90% in the next 1600 biggest companies. You're deciding that's the best you can do. An aspect of how those five companies in particular will perform, is how much money they can make in dollars, euros, yen and others, and what those measurement tools (fiat currencies) are worth in pounds. You can certainly tweak your portfolio through derivatives or hedges to see what would happen if the currencies could not freely float against pounds, but it would be an expensive thing to do long term, in terms of performance. But if you define 'performance' broadly to encompass volatility and other desirable traits such as avoidance of particular threats, perhaps it's fine.

aroominyork

bowlhead99 wrote: »

It's not a popular option because you are essentially saying you want low UK allocation (presumably don't trust UK markets and economy to do well, even though share prices are relatively low compared to p/e ratios elsewhere in the developed world) ; but you also don't trust UK economy /not/ to do well, so you fear sterling strengthening significantly.

You could buy the iShares MSCI World GBP Hedged UCITS ETF (Acc) from most UK stockbrokers or investment platforms that deal in UK-listed ETFs, ticker IGWD. It hedges the international assets monthly to GBP using forward contracts, though will of course be an imperfect hedge and its running costs will be higher than an unhedged version. Not just the OCF compared to the cheapest more popular unhedged products, but the hidden implicit costs of funding the hedge through rolling forward contracts.

(https://www.ishares.com/uk/individual/en/products/251892/ishares-msci-world-gbp-hedged-ucits-etf)

Of course, the flipside of the 'benefit' of hedging is that if/when the assets fall in value and sterling weakens further which would have offset the fall - or even if the international assets stay at the same prices in their local currency while sterling weakens - the value of your investment won't benefit from that weakening. Unlike the pension and ISA assets of your fellow countrymen who didn't hedge.

Alternatively, HSBC's Global Strategy multi-asset funds of funds series have some partial hedging of their overseas equities and more comprehensive hedging of their overseas bonds, to help them stay within their risk / volatility targets. But the hedging there is not as heavy as on the iShares ETF mentioned.

A number of hedged share classes exist for internationally-invested ETFs if you were looking to replace holdings for individual countries. Here's a factsheet for the iShares Core S&P500 GBP Hedged (GSPX) . They also have a slightly more expensive but longer-running standalone GBP hedged product for the S&P (IGUS). Of the two S&P500 hedged offerings from iShares, GSPX would seem to be the one to get, due to lower costs and greater size and liquidity, as well as a better performance over the last 12 months. Though the performance difference may just be a measurement difference, I haven't checked; and GSPX is a dividend distributing rather than accumulating product.

It can be seen by comparison with the 'real' underlying index that the returns are compromised when hedging. For example the unhedged benchmark S&P500 index gave a 1 year return to end of November of 15.41%. The hedged version GSPX gave only 13.15%, which is 2% worse even after adjusting for OCF, so in that case you might have been better to take the US result and the small FX translation loss. The rates only moved from $1.28 to $1.29 during the period, which is less of a drag than the implicit cost of hedging. Really, hedged products are acknowledged as being more expensive but provide some protection in case of a much bigger movement than we observed over the year to November.

Disclaimer, I have a small holding of GSPX in my pension - only about a percent or two of my portfolio, acquired pre-election, just for fun. It was quite nice watching it not fall with my other dollar-influenced holdings while the pound rallied from the high 1.20s to 1.35 over the course of a few trading sessions, but the fx rate strengthening didn't persist for long and then reversed.

This is very helpful as I am also looking into currency hedging. I have a few questions please. First, I had not considered ‘hidden costs’ of hedging. Does that relate to the costs inherent in trading/hedging currencies (“rolling forward contracts”) separate from the OCF? Is there a more straightforward way to calculate these additional costs than comparing the hedged and unhedged versions and trying to strip out the currency movement, or is there perhaps a ballpark figure it generally comprises?

Second, do you have a view on XDPG (which I hold) compared to IGUS and GSPX?

Finally, I have been considering IGWD as a global developed country hedged fund but had not come across the cheaper (and much larger) IWDG. The holdings seem very similar. What is the difference, eg between iShares III and iShares V? What are these different iShares ‘families'?

MaxiRobriguez

If the currency strengthens it will be because of UK PLC sentiment improving, at which point (or because of) FTSE250 companies will outperform as their valuations are cheap and dividend yields are high relative to rest of the world.

No need to hedge the currency, just over-allocate to UK domestic stocks if you think GBP will strengthen.

bowlhead99

aroominyork wrote: »

First, I had not considered ‘hidden costs’ of hedging. Does that relate to the costs inherent in trading/hedging currencies (“rolling forward contracts”) separate from the OCF? Is there a more straightforward way to calculate these additional costs than comparing the hedged and unhedged versions and trying to strip out the currency movement, or is there perhaps a ballpark figure it generally comprises?

In one sense there can be no hidden costs in any fund because you can see what the net return of the fund is and compare it to a benchmark index (rebased as you wish for currency rates, at the beginning, end, and during (in the case of dividend reinvestment).

In another sense, some costs are 'hidden' because they are a drag on a fund's performance without being explicitly listed as an 'ongoing charge'. You get that for example in a fund that has a high uninvested cash balance for liquidity purposes. The money is not invested at all times, so the performance lags what it would have been if the money had been fully invested. But there is no 'cost' in the profit and loss account, to be shown in the OCF - because "failing to make as much profit as you could have made" is not an 'expense'.

If you have a hundred million dollars worth of dollar assets, you can agree with a bank, using a 'forward contract', to sell $100m for an agreed amount of GBP at the end of next month. If today's spot rate implies they would receive £76.3m, the forward price they agree may give them £76.2m or £76.1m instead. The price will be determined with regard to interest rate differentials between the countries and market spreads etc. When they actually get to the next month and the contract approaches maturity, perhaps the market rate has moved so that $100m buys £74m or £77m on the open market, and their obligation to sell $100m for £76.2m represents an asset or liability with its own market price - you could sell the contract to someone else.

The loss that the fund gets from its $100m of dollar assets becoming worth only £74m at market spot rates, would be offset by gains on the value of the contract; they have an agreement that they can exchange $100m of cash for £76m of cash, which is valuable for someone in the market. Trillions of dollars of currency are bought and sold daily so there would always be a buyer for the contract at a sensible price. Sometimes the fund will make a profit on the contracts to offset its investment fx losses, and sometimes it will make losses on the contracts to offset its investment fx gains.

They do not in practice want to liquidate the portfolio of dollar assets and sell that amount of dollars to buy pounds, because they want to keep their holdings of Apple and Microsoft etc and do not want £76million of sterling cash. So they sell the contract - or let it mature and 'cash settle' it (paying or receiving the difference to market spot plus spread) while buying a new one for the next month to give certainty over what their $100m would give them next month (or next year) in GBP.

Of course in the meantime the $100m of assets (equities and cash) they first held, may now have become worth $105m or $95m depending on performance of those underlying investments. So the hedged amount may go up and down and may run a month at a time or a year at a time or some other maturity range.

What is clear is that they can't do that for free. But currency contract realised and unrealised gains and losses will go into the same part of the financial statements as the other investment realised and unrealised gains and losses, and not necessarily be seen as an 'ongoing charge', even though there is an ongoing cost to that pattern of activity - the bank always wins in terms of bid-offer spreads, and the interest rate differentials for the obligation to buy or sell currency need to be funded for the period of the contract.

Long story short, comparing the hedged results to an fx-adjusted raw result will help you see the overall effectiveness of the hedge after the fact - though it will be a mixture of 'cost' and 'effectiveness'. You generally need to accept a dull nagging pain of cost, to avoid the short sharp shock of an extreme movement.

Remember of course that adding an extra financial counterparty to your portfolio (the bank or consortium of banks offering the forward contract) gives another potential point of failure. What if the counterparty can't make good on its commitment? Low risk, but non-zero.

Second, do you have a view on XDPG (which I hold) compared to IGUS and GSPX?

Not really. A long time ago I avoided some popular db-xtracker products from Deutsche as they were often synthetic while rival ETF providers offered full replication of the underlying holdings. These days they have some very decent products and the DWS brand has €100bn of AUM.

Out of apathy, I haven't bothered looking in detail at XDPG as I was only investing a few grand and the iShares Core product I had first looked at appeared 'good enough' for purpose. I see XDPG is based on the same underlying benchmark, so if it works for you, fine.

Finally, I have been considering IGWD as a global developed country hedged fund but had not come across the cheaper (and much larger) IWDG. The holdings seem very similar. What is the difference, eg between iShares III and iShares V? What are these different iShares ‘families'?

Different product ranges launched at different times. The iShares Core range (encompassing IWDG and GSPX and a bunch of unhedged mainstream trackers) was launched 7-8 years ago with a focus on offering well-known popular indexes at low cost. In launching some new funds and repackaging other existing ones under the 'core' banner with more competitive prices, they helped hold off competition from the likes of Vanguard who threatened to encroach on market share with low costs and good marketing. Over time, they've added more under the brand without necessarily withdrawing the old equivalents.

In some cases there could potentially be better liquidity (therefore, better spread) from an old non-'Core' product, depending who holds it and trades it. A bigger fund is not necessarily more heavily traded, as a chunk may be held long-term by a strategic investor or indeed by another internal Blackrock product or partner. The 'umbrella' vehicle (e.g. iShares III or IV or V) is largely irrelevant to you the end investor, as each sub-fund has its own segregated balance sheet, with the headline vehicles simply being a quirk of corporate administration and prospectus-issuance.

Of course, read the prospectuses and DYOR before jumping in.

SlaveToMyCats

Great discussion, really appreciate the insights.

bowlhead99 wrote: »

Whereas here, you believe you can get a better result for yourself by overriding the raw market returns and instead skewing the result through derivatives. This is a form of active portfolio management, which you had implied was worthless because professional managers couldn't reliably do it, despite being supported by analysts, market information etc.

Yes its a fair point. I am wading into 'amateur active management', and yes I don't believe in this.



I'd love to say my motivation is simply that I believe that long term buy and hold of equities has a positive expectation, and therefore I want to simply exclude or remove currency risk and volatility where I have no edge.


But... the real reason is that I am speculating that sterling will eventually revert to close to its pre-ref level. I know this is inconsistent with my beliefs. The best way I can explain it is that (like many) my pension already benefited from the falling pound. I now want to take profits and hold no position in GBP at all i.e. winning by timing my exit.



Something I just came across just now is Nutmeg (Robo Advisor) which proposes a currency hedged pension by default (which seems unusual). They even show a breakdown of funds on their website. They have a blog which explains their approach but I can't post links yet.


That said, I am coming round to the idea that its just not that easy to exclude currency movements from foreign investments.. If a partial reversion did happen, over a period of 5 or 10 years, then the ongoing costs of maintaining a hedged portfolio could well outweigh it. I am now thinking in terms of low cost funds with a small to moderate UK bias (basically what I have now!)

MaxiRobriguez

For GBP to revert to a longer term mean there has to be a reason for it to happen, whether that's Brexit happening without any bumps or whether productivity starts to pick up again.

I'm not convinced GBP is going to recover and we're likely to be as you are for a number of years.

if you do think GBP will recover then it probably makes more sense to be in UK equity now. Get advantage of the decent dividend yields and the cheap prices, get some decent capital appreciation and then rebalance them some point down the line with GBP being stronger giving you bigger buying power of non-UK assets further down the line.