The Impact of Forex on Portfolios - By Daniel Gauci

Have you ever wondered, what are the most important factors in determining investment returns? Chances are you haven’t. Even less, would it spring to your mind that the interplay of currencies could have significant weight on the returns of your portfolio.The fact that since 2007, we have adopted the Euro as our national currency the currency we share with our main trading partners, has meant that we have put most of our worries regarding exchange risk on the back burner. 

Yet currency remains by far the single most traded asset globally, oustripping trade in comodities, equities or any other instrument. In order to have an idea, according to the Bank of International Settlements, average currency trading averaged $5.09 trillion per day in 2016. You may ask why is this? The answer to such question lies in what currencies represent, and what they stand for. In very basic terms, a currency represents the value of the demand and supply for a nation’s resources in the forms of; goods, services, natural resources and outright currency speculation.

Leaving behind the good old days of the Bretton Woods, Gold standard, most currencies have been “free-floated”, with the market forces being the determinants of the currency values, of one against another. Ever since, different currency pairs have experienced different periods of fortunes, and in certain cases busts. There are a lot of underlying forces that determine the value of a currency which for brevity’s sake we cannot visit. However all we need to keep in mind is that what drives the value of a currency against another, is the output of the economy’s performance and the demand for the countries goods and service, in very basic terms.  

The drive towards diversification, has driven investors to have global allocations across different regions. This implies that the same investors are exposed to the underlying currencies that make the portfolio. This creates a layer of risk-return to the client’s portfolio which adds another dimension to the total return generated from the investments whose underlying currency is in currencies other than their home currency in which they deal. Investments held in a currency other than the investors’ home currency, can appreciate or depreciate according to the underlying forces which drive the value of currencies against one another.

Investigating the potential impact of this on a portfolio we can take the following example. If a client exchanges his Euros, to purchase an equity denominated in US Dollars, his return will depend firstly from the change in value of the same asset and secondly his return will be impacted by the change in the value of the US Dollar against his home currency in Euro. The equity may also generate a level of income that is received by the investor which is also subject to this factor.

One of the decisions investors need to take when selecting their investments which will be denominated in another currency, than that of their home country, is whether to hedge their currency risk or not. On one side, if the foreign currency appreciates against the home currency, the investor stands to make a gain. Meanwhile the opposite applies if the home currency appreciates against the foreign currency. This decision is normally taken in regards to the risk tolerance level of the client.

For low to medium risk clients it is not normally advisable to carry the currency risk. Therefore one could select to hedge part of their investments in foreign currency. Hedging is the practice of ensuring a stable rate of exchange by buying future contracts to exchange currency at a specific rate. Similar to an insurance policy hedging costs money, and therefore this context is normally added to the equation when considering whether or not to hedge.

In times of volatile currency markets or when investing in emerging countries’ currencies, the cost of the hedge would accordingly be more costly reflecting the added risk to providing the hedge. For this reason, despite the fact that hedging reduces risk, it will also eat away part of the returns generated. For clients who have a moderate to high risk level profile, with the help of their financial advisor they could discuss and decide what level of currency risk is appropriate to them and in turn how much they can afford to be invested in foreign currency denominated investments.  

In order to provide further perspective; since touching the value of €1: $1.38, in May 2014, the Euro lost ground to the US Dollar reaching the €1: $1.05 level in March 2015. For an investor who would have invested €1,000 into US Dollar, by the end of the period, the investor would have gained 37% over this short period as a result of currency fluctuation only excluding any returns on investment.

These fluctuations take place over and over again and are mainly observable over the arch of the years. Conversely, investors in the Turkish Lira saw their investments retreat by an annualised 33.2% during 2018.

The volatility levels that we see, both in what are the major currency pairs and those of emerging countries, re-enforce that investments should be viewed as a long term commitment. Similar to the investments, in forex, investing for the short term can adversely impact the investor’s portfolio.

Comparing investments returns, affirms that foreign exchange can have a significant impact on a client’s portfolio. When deciding to take on currency risk within a portfolio, investors must be aware of the level of risk this represents, which is very often discounted by investors. On the flipside, having portfolio allocations in currencies other than the investors home currency can help mitigate the impact of a decline against a basket of currencies of the investor’s home currency. 

This article was prepared by Daniel GauciHnD Management, CeFa Investments, Investment Advisor at Jesmond Mizzi Financial Advisors Limited. This article does not intend to give investment advice and the contents therein should not be construed as such. The Company is licensed to conduct investment services by the MFSA and is a Member of the Malta Stock Exchange and a member of the Atlas Group. The directors or related parties, including the company, and their clients are likely to have an interest in securities mentioned in this article. Investors should remember that past performance is no guide to future performance and that the value of investments may go down as well as up. For further information contact Jesmond Mizzi Financial Advisors Limited of 67, Level 3, South Street, Valletta, on Tel: 2122 4410, or email [email protected]http://www.jesmondmizzi.com








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