Hedging against currency is a challenge

Currency hedges will be more attractive when the dollar declines, but outcome complications could arise from fluctuating exchange rates

Even though sterling was steadily declining and the US dollar was steadily strengthening, British investors rarely had to be overly concerned about currency fluctuations. If you owned an international fund that was based on the MSCI World index or something comparable, you were exposed to about 6070% of the US dollar, and the trend was in your favor.

This will no longer be advantageous to us if the Trump administration's policies indicate that the strong dollar era is over.

A weaker dollar would result in significantly smaller gains for foreign investors, even if the US stock market continues to rise, which is quite possible if the US Federal Reserve aggressively lowers rates.

One obvious conclusion is that investors will consider currency exposure much more carefully, for example, by purchasing exchange-traded funds (ETFs) that are currency hedged.

An ETF like iShares Core SandP 500, for instance, is offered as a share class that is hedged into sterling (LSE: GSPX) and one that is quoted in sterling (LSE: CSP1). The way the dollar fluctuates in relation to sterling will have an impact on the first. There will be a limit to how much the latter is hedged against it.

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The operation of currency hedged funds.

Thinking about how funds hedge currency exposure helps us understand why, even a currency hedged fund, won't fully protect us from currency movements over the long run.

By using forward contracts, hedging allows investors to fix the exchange rate at which they will purchase or sell a specific quantity of the currency at a later time.

It goes without saying that the locked-in exchange rate will differ from the current one. Every currency pair, including the dollar and sterling, has a forward rate for a transaction that takes place in a month, a year, five years, and so forth. The difference in anticipated interest rates during that time frame should determine the forward price. If not, an investor could profit risk-free by borrowing money in one currency, investing the proceeds in another currency for a month at a fixed interest rate, and purchasing a forward contract to convert the second currency back into the first currency (and pay back the borrowed amount) without having to worry about fluctuations in exchange rates.

Hedges can be precisely entered into if you have very specific long-term cash flows, such as those from an infrastructure project. You purchase forwards so that they precisely match the foreign currency you anticipate receiving upon receipt. This isn't the case for the majority of equity or bond ETFs or funds, where money may constantly come in and go out of your fund and future returns may be unpredictable. As a result, a currency hedged fund usually makes a number of short-term forwards that it keeps rolling over. In a world where interest-rate expectations and, consequently, forward exchange rates are more volatile, this may not always function as well as investors anticipate, even though it undoubtedly helps to reduce currency volatility.