Investing internationally can bring many advantages to a portfolio. It can provide exposure to different economic cycles, inflation rates and interest rates as well as bringing increased diversification. But it also exposes you to exchange-rate risk.
Sometimes, investing overseas can cause confusion when it comes to returns. Last year was a great example. The S&P 500, a key index of US shares, was up about 19%, but a UK investor in the S&P 500 only saw a return of about 9%. The previous year, things went the other way: the S&P 500 returned just over 9%, but a UK investor earned a whopping 31%!
Why the difference?
There may be many reasons. Fund costs, fees, trading costs and the gains or losses from active management are all things that can make a fund's return differ from its benchmark. In the case of international investments, however, there's another significant reason: currency fluctuations.
The mechanics of overseas investing
Here's how it works. Most foreign investments are priced in their home currency, but UK investors operate in pounds sterling. So if you use pounds to purchase an investment in an overseas market, the first thing you need to do is convert the money into the currency of the market concerned.
Using the S&P 500 as an example, you would convert your money into US dollars before it is invested. And in the future, when you want to sell the investment, you would receive US dollars, which you would convert back into pounds before depositing them into the account.
During the time the money is invested, it's in US dollars, and the value of those dollars relative to sterling will be constantly fluctuating. That creates an additional source of return, which could be positive or negative.
If the value of the dollar increases relative to the pound, as it did in 2016, the investment will make more money, because it will return more pounds per dollar when sold. And if the dollar weakens, as it did in 2017, it will produce less because those dollars will buy fewer pounds when it's time to sell.
US dollars is used in the example, but the same principle holds for all overseas currencies.
It all evens itself out in the long run
For most long-term investors, these currency movements mean very little, because they tend to cancel out over long periods due to economic cycles. Over shorter periods of time, however, currency fluctuations can make a significant difference to portfolio returns.
In 2017, the change in the exchange rate worked against UK investors but, in fact, the last several years have generally been good for UK investors. Since 2004, sterling investors in US equities have enjoyed cumulative gains about 30% higher than their US dollar counterparts.
This strong performance for UK investors was driven by a dramatic decline in the value of the pound relative to the dollar between 2004 and 2017, from about $1.91/£ to $1.35/£. This decline was part of a broader weakening in sterling against most major global currencies, a decline that we do not believe will be repeated over the coming years.
Key points to remember
- Investing internationally is a great way to diversify.
- Currency fluctuations mean the return on foreign investments won't always match the index returns.
- For long-term investors, currency fluctuations are likely to cancel themselves out.
- For those who have shorter time horizons, hedging may be an option