Imagine you’re looking at a fund that invests in Thailand. You’re a British investor and what ultimately matters to you is your investment return in sterling.
The fund has two share classes, one in sterling and the other in US dollars. You have a negative view on the dollar, expecting it to fall against sterling in the year ahead. Which of the fund’s two classes should you buy?
Many investors – even experienced ones – will say the sterling class. But in most cases, it makes absolutely no difference. You can pick either and you will end up with the same return in sterling terms.
If that’s not immediately obvious to you, you’re not alone. Currency risk of foreign currency-denominated funds is one of the most misunderstood parts of international investing.
The key point to understand is that the currency a fund is quoted has no impact on returns by itself. What matters is your domestic currency and the currency of the underlying assets that the fund holds.
In this article, I’ll demonstrate why that’s true – and explain why many funds still offer multiple currency classes anyway.
Different classes, same return
First, let’s use some real numbers to demonstrate the statement I made above.
Imagine that you put £10,000 into the sterling shares of a fund that invests in Thailand at the beginning of 2010. At the time, the THB/GBP exchange rate was 54, meaning that you invested 54,000 baht.
The Thai market rose by around 50% between January 2010 and April 2011. By April 2011, the THB/GBP exchange rate was 49.3.
Your return in baht terms was of course 50%, giving you a total of 81,000 baht [=54,000×(1+50%)]. Your return in sterling terms was greater, reflecting the rise in the baht against sterling. Your sterling assets were16,430 [=(81,000÷49.3], a gain of 64.3%.
As an alternative, let’s assume you put your £10,000 into the US dollar shares of the same fund. In January 2010, the USD/GBP rate was 1.617 and the THB/USD rate was 33.39. So your £10,000 becomes $16,170 [=10,000×1.617].
That is then converted into baht at the USD/baht rate. Ignoring a small rounding error, you again end up with 54,000 baht [=16,170×33.39].
The market rose by 50%, again giving you a total of 81,000 baht by April 2011. The baht had also appreciated against the dollar and THB/USD was 29.99.
That means that the US dollar investment in the fund is now worth $27,000 [=81,000÷29.99], a gain of 67% on the initial US dollar value of the investment. This reflects both the stockmarket gain and the fall in the value of the dollar against the baht over the period.
To calculate your overall return, we then convert that back into sterling. The USD/GBP rate was 1.644 – in other words, sterling has strengthened a little against the dollar. Your sterling assets were £16,430 [=27,000÷1.644], which is again a return of 64.3% on your original sterling investment.
The table below summarises all these steps.
Investment in sterling class Investment in US dollar class
Initial investment in sterling £10,000 £10,000
Convert to US dollars N/a 10,000×1.617
Subtotal £10,000 $16,170
Convert to baht 10,000×54 16,170×33.39
Subtotal THB54,000 THB54,000
Local stockmarket returns 54,000×(1+50%) 54,000×(1+50%)
Subtotal THB81,000 THB81,000
Convert to US dollars N/a 81,000÷29.99
Subtotal THB81,000 $27,000
Convert to sterling 81,000÷49.3 27,000÷1.644
Subtotal £16,430 £16,430
Return on initial investment in sterling terms 64.3% 64.3%
As you can see, whether you invested directly in the sterling share class or in the US dollar class, you ended up with the same return in sterling terms.
Understanding the FX triangle
Why is this? To understand, you need to remember that the three exchange rates (THB/GBP, THB/USD and USD/GBP) are not separate numbers but as a connected triangle of exchange rates. When you change one exchange rate, you must change one or both of the others in a way that keeps a consistent relationship.
For example, if sterling rises against the dollar, then if THB/USD does not change, sterling must rise by an equal amount against the baht. Alternatively, THB/GBP may remain constant, in which case the baht must rise by an equal amount against the dollar. Or – more likely in reality – THB/GBP, THB/USD and GBP/USD will all change to differing extents.
If this didn’t happen, you would be able to earn risk-free profits from arbitraging exchange rates. Imagine that USD/GBP rose by 10%, while the other two rates remained unchanged. In that case, you could earn a guaranteed 10% by buying dollars with sterling, then buying baht with dollars and finally buying sterling again with baht.
Obviously, this isn’t possible. The foreign exchange market is highly liquid and highly efficient, so even tiny arbitrage opportunities which emerge are traded away very quickly.
As a result, we find that however we go around this triangle of FX rates, we must come to the same result. Going sterling to baht and back to sterling must produce the same result as sterling to dollar to baht to sterling or sterling to dollar to baht to dollar to sterling.
So for a sterling investor in baht assets, it is just the change in the THB/GBP rate that matters. Whether the fund that holds those baht assets is quoted in sterling or dollars and what path the money takes when it’s changing currencies makes no difference.
Why funds offer several currency classes
In fact, the vast majority of global foreign exchange trades take place through the US dollar in any case. So even if you invest in the sterling class of a fund that invests in Thailand, it will probably convert your money into US dollars before converting that into baht – and the same on the way back.
So in that case, why do funds offer different currency classes? Why not just offer a single class?
I’ve asked several fund managers about this – and “I’ve no idea, it never makes sense to me either” was a very common reply. When I finally got an explanation, it came not from the managers but from a couple of their marketing teams.
The first reason is to make things simpler for investors:
- Since many buyers don’t understand that currency the fund is quoted in is not relevant and prefer to have a sterling class to avoid an extra (non-existent) risk, it’s less hassle to supply it than to explain how currencies work.
- Converting money from sterling to dollars creates an extra step before investing in a fund. Brokers now do this automatically, but it wasn’t always so straightforward – and the more difficult something is, the less likely an investor is to do it.
- Having all funds and assets presented in the same currency makes it easier for an investor to keep track on the performance of a portfolio in sterling terms.
The second reason is that most of the UK fund supermarkets will only accept a fund onto their platforms if it has a sterling share class. And since ever more funds are purchased through supermarkets, providers need to meet their requirements or lose an important sales channel to investors and advisors.
If it’s not hedged, it doesn’t matter
Of course, what I’ve said above only applies to unhedged share classes. Where there is a currency hedge involved, the results will be different.
To continue our earlier example, a sterling investor in a US dollar hedged class of the Thai fund would have earned a return equal to the return of the Thai market in baht terms plus the change in the USD/GBP rate less the cost of hedging.
If you are investing in a hedged currency class, you need to be aware of this. However, most currency classes for most funds do not involve hedges, so in most cases this does not apply.
Obviously, there may be reasons to prefer one class over the other. You may find it simpler to deal with a sterling class to monitor your investments. Your broker or fund supermarket may offer one class and not the other. A choice of income and accumulation classes may not be available in all currencies. Occasionally, fees may vary between classes.
But the currency class is irrelevant to your returns. So make sure you don’t wrongly reject funds just because of the currency they are quoted in.