6th March 2012
Most vitally, have both advisers and shareholders got the traditional formula that says strong pound bad, weak pound good for overseas investments so go with the strong and avoid the weak? A Financial Times article which draws on the Credit Suisse Global Investment Returns Handbook 2012 would suggest this long standing concept needs a rethink.
Some of the explanation for the huge ratio held in the UK is historic. A substantial percentage of UK open-ended funds have been held for more than two decades – going back to a time when China and many other nations either had no stock market or one that barely functioned.
More important, however, is investor conservatism – the fear of the foreign, the urge to avoid the unknown. But there is also a more concrete caution – currency exchange rates.
Investors see this as a risk in addition to that inherent in equities. For safety-first investors, the volatility in shares may be as far as they want to go – they don't fancy a second foreign exchange layer of uncertainty.
And this is despite the fact that currency moves can work positively.
Advisers have always put forward a simple explanation. When the pound goes down, your foreign investment goes up and when sterling is on the rise, then what you have in other currencies loses value. The UK currency has seen weakness rather than strength over the past 70 years so this should have reassured investors. And those willing to put money outside the orbit of the UK Borders Agency have grown.
So nervous have some investors become, that advisers and fund managers try to tempt them into global equities via funds which promise to remove the exchange rate risk – admitted at a cost – by hedging the foreign currency back into sterling. Does this work?
Currency neutrality scores
A posting on currency-hedged funds on the Canadian Capitalist site comparing unhedged and hedged (currency neutral) ETFs says: "In the past couple of updates on the performance of currency-neutral funds, we found that these funds do not quite live up to the expectation of removing the effects of currency fluctuations for a modest cost."
But now new research suggests that that the traditional adviser formulation should be stood on its head. Academics at London Business School (Paul Marsh emeritus professor of finance at LBS, and his colleagues Elroy Dimson and Mike Staunton) contributed work on currency factors for the Credit Suisse publication.
Their study says "investing in global equities, rather just domestically, reduces portfolio volatility." Nothing new in that. But their next statement will surprise many. Concentrating on equities – bonds are another story – they find "equities perform best after periods of currency weakness, which suggests that more unhedged cross-border stock exposure can be desirable at those times."
"Investors enjoy gains from investments in countries whose currencies appreciate and suffer losses when currencies depreciate, so they often argue that it is better to invest in countries with strong currencies. But the ‘strong currency is good' school does not get much support from this research," the academics say.
Need to predict
While it remains true that foreign currency gains can enhance portfolio values, they say "this is only true if one can successfully predict which currencies will be strong in the future. All we know for sure is which ones have been strong in the past."
Their advice is to buy after a period of currency weakness as this, their research based on figures stretching back to the late 1970s show, can produce the best equity uplifts.
Why? This is no "definitive answer" but anecdotal evidence would suggest a weak currency encourages exports and discourages imports and that asset prices reflect international rather than national values. Another explanation is that a weak currency encourages greater volatility which, coupled with the recovery factor economists say should be part of a devaluation, can encourage equities upwards.
"You would expect countries with distressed currencies to be more volatile, and indeed they are, but that is not high enough to get rid of the differential of the return," the report says. And what is more, their data suggests the value of currency weakness lasts for as long as five years. It is not a one off.
More recently, the strong is good argument has had a setback or two. Both the Swiss and the Brazilian authorities have moved in to prevent their currencies from rising too far.
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