Sterling's Sway: Making Currency Exposure a Conscious Portfolio Decision

The exposure hiding in plain sight

A UK investor who buys a global equity fund or an overseas bond fund is usually making two decisions at once. The first is the familiar one: which assets to own. The second is less visible but no less real: which currencies to own. For a sterling-based investor, an unhedged holding in US equities, Japanese shares or European corporate bonds carries a currency exposure that sits alongside the investment itself. The fund may be reported in sterling, but that does not mean the currency risk has been removed. It has simply been translated into the investor's base currency.

This matters because reported returns are shaped by both the underlying asset and the movement between sterling and the currencies in which those assets are denominated. If overseas assets rise in local terms but sterling strengthens, the sterling-reported gain can be reduced, eliminated or turned into a loss. If sterling weakens, the opposite can occur. Currency is not a side issue to be left to chance; it is part of the return stream, and it deserves a deliberate place in portfolio policy.

How sterling changes the arithmetic

For a UK investor, the relevant question is not simply whether global markets rose or fell. It is what happened to those markets after conversion back into sterling. A US equity fund may hold companies whose revenues are global, but its shares are priced in dollars. A euro-denominated bond pays coupons in euros. When sterling moves, the sterling value of those assets moves with it.

This effect can be modest over short periods or pronounced over others. Currency movements are difficult to forecast and can persist for longer than many investors expect. That is precisely why the decision should not be based on a view about the next few months. It should be based on the investor's objectives, time horizon, spending currency and tolerance for volatility.

Currency exposure also behaves differently across asset classes. For long-dated equities, currency movements may be one influence among many, and some investors regard unhedged global equity exposure as a form of diversification away from sterling. For bonds, the picture can be different. A government bond is often held for its yield and stability, and an unhedged currency exposure can overwhelm the modest return the bond was intended to provide. This is why hedged share classes are more common in developed-market bond funds than in global equity funds. The logic is not universal, but it is worth understanding.

Hedged and unhedged share classes

A hedged share class aims to reduce the effect of currency movements between the fund's underlying currencies and the investor's base currency. It typically uses forward foreign exchange contracts to sell the foreign currency exposure and buy sterling exposure. The intention is not to eliminate all risk, but to make the fund's return behave more like the local-currency return of the underlying assets.

Hedging is not free. The cost is not usually a simple annual fee printed on the factsheet. It is embedded in the difference between interest rates in the relevant currencies, together with the operational costs of rolling forward contracts. When UK interest rates are higher than those in the currency being hedged, hedging can add to returns; when they are lower, it can subtract. Those effects can change over time, so a hedged share class should not be chosen merely because it sounds more cautious.

There are other practical considerations. Hedged share classes may have higher ongoing charges than their unhedged equivalents, and not every platform offers every class. Hedging can introduce counterparty and operational risks, although these are generally managed within the fund structure. The hedge may also be imperfect, particularly where a fund holds a wide range of currencies or where the underlying portfolio changes. In short, hedging is a tool for managing a specific risk, not a guarantee of a better outcome.

Why behaviour matters as much as cost

Currency exposure affects more than the final return figure. It influences the experience along the way. An unhedged global portfolio will have a different pattern of gains and losses from a hedged one, even if the underlying assets are identical. For some investors, that additional variation is acceptable in exchange for diversification away from sterling. For others, particularly those close to drawing on their portfolio, it may be unwelcome.

The key is to avoid making the decision by accident. A UK investor may hold unhedged global equity funds, a hedged global bond fund and a sterling cash reserve without ever having decided what the overall currency mix should be. That is not a policy; it is an accumulation of separate choices. A written investment policy can bring those choices together. It need not be complicated. It should state the base currency, the investor's spending needs, the intended role of each asset class and the acceptable range of currency exposure.

A practical framework for UK investors

First, measure the exposure. Look through funds to understand the currencies of the underlying assets, not just the currency in which the fund is priced. A global fund may be reported in sterling while holding assets across several currencies. Second, separate the decision by asset class. It may be reasonable to accept unhedged currency risk in a long-term equity portfolio while preferring a hedged approach for developed-market bonds held for stability. Third, consider the cost and availability of hedged share classes. A hedge that is expensive, difficult to access or poorly understood is unlikely to be a good default.

Fourth, test the portfolio against sterling scenarios. A simple stress test can be informative: what would happen to the portfolio if sterling rose or fell by 10 per cent against a basket of major currencies? This is not a forecast; it is a way of understanding the range of outcomes. Fifth, set a policy range and review it. Currency exposures drift as markets move and as portfolios are rebalanced. A range, rather than a fixed target, allows for practical management without pretending to precision.

Finally, document the reasoning. The value of a currency policy lies less in getting every future move right than in creating a consistent framework for decisions. If sterling weakens and overseas returns are flattered, the policy explains why the exposure was held. If sterling strengthens and returns are muted, it explains why that was accepted. Over time, that discipline is more useful than reacting to each currency move as though it were a signal.

A deliberate place in policy

Currency risk is not an argument for avoiding global diversification. It is a reminder that diversification has a currency dimension, and that UK investors should decide how much of it they wish to carry. For some, an unhedged global portfolio will be appropriate. For others, a blend of hedged and unhedged exposure will better match their liabilities and temperament. The measured approach is not to predict sterling, but to understand the exposure, price the alternatives and set a policy that can be reviewed calmly.