See CISI TV for a talk on this theme by Ben Raven
Let’s wind the clock back 20 years. A UK retail client has an adventurous risk profile and is recommended a portfolio of UK equities. Fast-forward to the present day and the geographical breakdown of the client’s portfolio will look very different. The reason is the global diversification of client portfolios, made possible by the development of an almost unlimited investment choice.
The same client now may have three-quarters of their portfolio invested overseas. There are numerous benefits for UK clients diversifying around the globe (current UK inflation and GDP vs the rest of the world being examples) and a financial adviser can construct, or recommend, a portfolio for retail clients that invests almost anywhere, in almost anything.
Global diversification of investment products has coincided with another significant development in the UK: the weakening of GBP. Over the past 15 years, GBP has lost 29% vs the USD, 25% vs the JPY and 10% vs the EUR. So, clients have seen their UK exposure decrease, their overseas exposure increase, and begun to own more assets denominated in overseas currencies. These currencies have then been strengthening against GBP, meaning their portfolio is likely to have benefitted from GBP weakness. I say likely as this will depend on whether or not their overseas exposure is being hedged back to GBP.
Where does this leave UK retail clients in 2018? They’ve probably enjoyed positive performance over the past 15 years. However, what proportion of these returns has been derived from the asset allocations they were advised on at the outset, and what proportion has really been derived from the weakening pound? Put another way, how much has come from the currency risk clients may not even have known they were being exposed to?
IA sector analysis fails to identify the proportion of returns arising from asset allocation vs the proportion arising from currency moves
If we use the Investment Association (IA) sectors as an example, we can see that over the past ten years, the IA Japan, North America and European Smaller Companies sectors have made the following total returns in their respective native currencies (eg, a Japanese client investing via a JPY share class).
Source: Lipper for Investment Management & Thomson Reuters Eikon 31/03/03–31/03/18
However, UK retail clients tend to invest through GBP share classes and if we look at the returns of these same sectors, in GBP terms, the results are strikingly different.
Source: Lipper for Investment Management & Thomson Reuters Eikon 31/03/03–31/03/18
Some funds operate with multiple share classes, but IA sector returns are calculated using only one share class per fund: typically, an unhedged GBP share class. IA sector analysis therefore fails to identify the proportion of returns arising from asset allocation vs the proportion arising from currency moves, nor does it explain the considerable, additional risks that currency markets expose clients to.
What does this mean for clients? A large portion of their returns may not have been derived from the investment strategy they agreed with their financial adviser. The weakening GBP has ‘boosted’ many clients’ returns. This was neither part of the intended investment strategy nor a risk that was explained to the client. Their expectation was that they were investing in, for example, equities. In reality, they were investing in two asset classes: equities and foreign exchange.
Volatile currency markets
Would we ever deem it appropriate to recommend a currency fund to a cautious client? The answer is almost certainly no, because currency markets tend to be more volatile than other asset classes. Why then do advisers recommend investments in global bond funds via unhedged GBP share classes which are riddled with currency risk? Advisers may not knowingly place clients into such funds, but inadvertently, it has become common practice for retail clients to be heavily invested in globally diversified, unhedged portfolios, carrying an equivalent or an even worse exposure.
Fortunately, over the past 20 years, investing clients in unhedged global holdings hasn’t really mattered because investment returns have been ‘boosted’ by currency moves. Whatever the outcome however, the client was being exposed to a type and level of risk they were most likely unaware of.
While GBP weakness has helped many retail client portfolios, we must remember that GBP is at the low end of historical averages against other major currencies. UK inflation and expected interest rate rises over the short to medium term are also likely to trigger a GBP recovery.
What happens if GBP returns to the levels of 20 years ago? Investment returns from global holdings would be substantially worse than historically, including delivering potential losses to clients, even when the underlying asset classes made gains. Cue the opening of a can of worms and perhaps the next misselling scandal in UK financial services.
Cause for complaint
Clients will have a legitimate complaint based on exposure to a type and level of risk if this was not explained to them at the outset. Their expectation was that they were investing in a portfolio of, say, equities and bonds. The reality was that they were invested in a portfolio of equities, bonds and currencies. The likely result was that their portfolio, at times, operated at a much higher level of risk than they had agreed. A portfolio risk rating represents the aggregate, historical, volatility of the specified asset classes within the asset allocation. A blend of 60% equities and 40% bonds may produce a portfolio risk rating of six. However, as soon as the currency markets start moving around, this six could quickly become a seven, eight, or even nine.
Reasons for not hedgingWould it be a viable defence to the regulator to say that clients were invested in a GBP share class and one assumed this mitigated currency risk? Or, claiming that currency risk is disclosed in the small print of the portfolio literature? What about the fund provider telling an adviser they deliberately decided not to hedge? Let’s consider each.
It is a widely perceived fallacy that investing in a GBP share class prevents a client being exposed to currency risk. When purchasing any asset denominated in a different currency, everyone is exposed to exchange rate movements between entering and exiting every trade. The risk is only mitigated if they either invest in a GBP hedged share class or have this exposure hedged elsewhere.
Fund providers must make full disclosure in the small print, but fund providers do not make investment recommendations to clients. Clients must be made aware of all risks affecting their portfolio prior to investment. Whether or not the fund provider is highlighting these risks, it is the financial adviser’s job to ‘look under the bonnet’ as they are the liable party. I will explain shortly why fund providers may not be forthcoming with these risks.
Fund providers may decide not to hedge because hedging overseas exposure results in a higher ongoing charges figure (OCF), or because currency markets tend to ‘even themselves out’ over time. Either is a legitimate position for them to adopt because their goals are, generally, raising assets under management (AUM) and generating the best risk adjusted returns for the fund. Their outlook and timescales often contrast markedly with a client’s best interests. Imagine a client invests when the GBP cycle is in a ‘trough’ and sells when it is at a ‘peak’. GBP strengthened and the client was detrimentally affected – no issue for the fund provider, but a big one for the adviser making the recommendation.
What about fund providers who do not hedge because there are separate currency trades forming part of their investment strategy? WARNING – READ CAREFULLY – currency exposure as part of a macro trading strategy is not the same thing as hedging overseas exposure back to GBP. The former is a trading call within the context of the fund’s investment objective, the latter is a type of risk that can quickly cause a portfolio to become unsuitable for a client.
These three reasons for not hedging are valid within the context of making decisions in the best interest of the fund. Why then would fund providers not be completely forthcoming with financial advisers about the impact of currency risk on a client portfolio? Why should it be up to the adviser to sift through 100 pages of small print across a range of offering documents to find the information?
The simple truth: the interests of a fund provider are often quite different to those of an adviser. Fund providers are in the business of selling; of selectively telling advisers all of the benefits they wish to hear, but not quite so enthusiastically providing information that may impact an adviser’s decision to recommend their products.
Understanding the risksRemember, fund providers are under no obligation whatsoever to eliminate currency risk on behalf of retail clients. Fund providers do not make investment recommendations, nor do they have the liability for ensuring those client recommendations remain suitable each year. A financial adviser is responsible for making sure that any recommended investment is suitable for each client at the outset, and remains suitable for that client over time. Fund providers make decisions in the best interests of their funds. Advisers must make every single decision in the best interests of their client.
How can advisers better understand these issues and the risks they pose to their business? Always ask their fund provider the simple questions: what percentage of my client’s portfolio is invested overseas? Is this exposure being hedged back to GBP? If so, how? If not, why? They must conduct adequate due diligence and ensure they make informed decisions in the best interest of their clients. They should no longer be willing to accept the perspective that ‘currency markets even themselves out over time’, or that other currency trades/exposures form part of the investment strategy.
The landscape in UK financial services has changed dramatically. We may be on the brink of the next financial sector scandal with the indicators staring us in the face. A silver lining for advisers is that the bomb has not exploded yet and there is still time to act. Are you certain your clients are taking the level of risk they signed up for? Is your business prepared for when GBP rallies?
This article was originally published in the Q3 2018 print edition of The Review. The print edition is available to all members who opt in to receive it, except student members. All eligible members who would like to receive future editions in the post should log in to MyCISI, click on My Account/Communications and set their preference to 'Yes'.