The Role of Foreign Exchange in Investing
Wealth management is the art of managing risk in an effort to optimise reward. For US citizens living in the UK, risk management needs to go beyond the classic issues of retirement planning involving how much money will be needed to retire, or at what age is retirement feasible. Expats need to also understand whether any foreign exchange risk lurks in their underlying portfolios.
For expats who are settling overseas for the long run, foreign exchange risk is complex but highly manageable – if you know how to identify and then anticipate the hazards. There are three areas where US citizens are likely to take on risk without always understanding the pitfalls. This includes:
(1) Planning investments in terms of their future liabilities – Will future expenses be mostly in dollars, pounds, or a combination or currencies?
(2) Being mindful of how to hold cash – Should cash be held in dollars, euros or some other currency?
(3) Not converting currency from one to another to make an investment decision due to exchange rate costs – subsequently ignoring the eventual underlying currency exposures of the investment made.
We explore each of these in a bit more detail below and provide tips for US expats on how to take charge of foreign exchange risks.
• Maintain buying power by selecting the right currency now for fixed income investing.
Traditional investment portfolios generally break down into three basic categories – fixed income, stocks, and cash. Each category plays a special role. Cash is important for emergencies; stocks are the growth engine, and fixed income investments should provide the basis for daily expenses after retirement or for mitigating the overall level of volatility in a portfolio. Foreign exchange risk in fixed income portfolios is singularly important to manage and you should consider having the right mix of dollar and pound-based fixed income investments. US citizens living overseas should look at matching the income from their investments to the local currency where they will be incurring most of their expenses. This will protect from exchange rate fluctuation. You don’t want to suddenly discover after decades of saving that the largest component of your portfolio is in dollars rather than the currency of your liabilities or vice versa.
• Pay attention to cash – is it in a local currency?
Everyone needs to keep cash – or cash equivalents – on hand for emergencies. In our experience we sometimes find that globetrotting clients can be indifferent to the currency in which they hold cash. If you are living in the UK and keep cash accounts in euros as well as dollars, then you are subjecting yourself to currency risk. This is true for cash equivalents, like US Treasury bills or money market funds. If you suddenly need £30,000 to replace your car, you don’t want to convert your cash from another currency. The foreign exchange market is vast – more than $5.3 trillion trades daily. But the price volatility is considerable. You could get lucky, and the currency you hold could strengthen. But in effect, you are playing roulette with your reserves.
• Don’t be afraid to change dollars to invest in US-based global stock funds.
Stocks, real estate and commodities – these are the assets that can help to power growth in a nest egg. For many US investors living abroad, buying US-based funds is typically the most efficient way to build a globally diversified portfolio of real assets. Diversifying is critical: it helps to outweigh the true risk of currency fluctuation and keep the return engine of a portfolio humming. We have found that a number of investors hesitate to swap their pounds for dollars. They think that they will get killed on exchange rate costs. However, if your wealth adviser has correctly set up efficient foreign exchange banking services, those transaction rates should be trivial.
Investors also mistakenly assume that they are taking on dollar risk if they exchange pounds for dollars in order to invest in a US global stock fund. Buying US funds is often considered the most tax-efficient venue for expats and the investor needs to distinguish between the denomination of the investment and the true foreign risk exposure. The currency risk for a US person permanently living in the UK, buying a dollar denominated fund, that buys stocks in Europe, is the movement between the euro and pound – not the relationship between the US dollar and pound. If you exchange pounds to buy a dollar-based emerging market fund, then the foreign exchange risk is pound vs. emerging market currencies. There is no dollar risk. The dollar is merely a reporting currency.
When it comes to stocks, the ups and downs of foreign exchange can indeed enhance or hurt returns in the short-run. Some managers may use fancy techniques to hedge – or protect – investors from the vagaries of the foreign exchange market. In the long-term, however, academic studies show that hedging isn’t all that effective when it comes to stocks.
Global diversification is seen as the best friend for savers. When investors understand just where currency risk lies, they can make choices about how to manage that risk. A misunderstanding of these risks can result in investors not being able to achieve their goals
For more wealth planning tips and tidbits from MASECO read our 39 Steps to Smart Living in the UK.
Risk Warnings and Important Information
The value of investments can fall as well as rise. You may not get back what you invest.
The above article does not take into account the specific goals or requirements of individual users. You should carefully consider the suitability of any strategies along with your financial situation prior to making any decisions on an appropriate strategy.
MASECO LLP trading as MASECO Private Wealth is authorised and regulated by the Financial Conduct Authority, the Financial Conduct Authority does not regulate tax advice. MASECO Private Wealth is not a tax specialist. We strongly recommend that every client seeks their own tax advice prior to acting on any of the strategies described in this document.