How do currency fluctuations affect my investments?
We usually only think about foreign currency when planning a holiday. Then suddenly exchange rates matter. Will our sterling buy more or less euros to use as spending money? But exchange rates can also affect our investments, from the dollar to the zloty.
It’s not just the price of rioja
- When a UK investor buys a UK fund or an European investor buys an European fund, the key variable is the stock price.
- If it goes up 10 per cent, so does your investment. Easy.
- But if a UK investor buys a European fund, currency is also a variable. Movements in the sterling/euro exchange rate will influence the income you will ultimately receive.
- That’s because the European fund will pay income in euros, which you then have to convert back to sterling.
Currency fluctuation and income from a fund
So here’s what happens to the returns.
- If sterling is weak against the euro, your returns will be enhanced when converted back to sterling. That’s because the euros will buy more sterling. Let’s say the fund pays €30 income a year on a £1,000 investment. If sterling is at €1.3, you will receive £23.08.
- If sterling strengthens, you will receive a worse return when converted to sterling despite the figure in euros staying the same. That’s because the euros will buy less sterling. If sterling is at €1.5, you will receive just £20. It makes a difference.
Currency fluctuation and share and fund prices
It’s also easy to overlook currency fluctuations when buying and selling shares or funds. To keep it simple, let’s ignore all transaction costs.
- You buy into an European fund at €50 a unit. At the exchange rate at the time, £1 buys €1.3, so each unit costs £38.46.
- Let’s say your investment does well and the unit price rises 20 per cent to €60. You might expect your unit to be worth £46.15, but sadly no. What the markets give, they can also take away.
- In this time, the pound has also strengthened, rising to €1.55. This means euros buy less sterling. So your unit is only worth £38.70. The exchange-rate rise has wiped out almost all the increase in value.
How to get around it (almost)
You can invest in currency-hedged share classes that aim to minimise the impact of foreign exchange-rate movements by reducing this exposure. But be warned.Currency hedging can never be fully accurate, so if you invest in a hedged share class you will only minimise your currency exposure rather than remove it completely.
We’ve illustrated, in an infographic, the various ways that currency fluctations can affect your investments.