Only the brave venture abroad

Yet again, the financial world is being convulsed by huge currency movements. The European Exchange Rate Mechanism seems to be falling apart following the peseta devaluation last week and the prospect of a franc and lira crisis looming in the near future. The dollar has also plunged against the mark, while the yen is the only major currency that looks at all stable. The Mexican peso and the Brazilian real, meanwhile, look bent on self-destruction as they head to ever lower lows.

Confused? You should be. Economists and currency experts certainly are since many have been caught embarrassingly on the hop by recent develoments.

But where does all this leave the poor benighted private investor who thought it might be nice to have a few US Treasury bonds or German equities in his portfolio? In the space of three days the dollar fell from $1.50 to $1.62 against sterling early this week while the ERM, a system specially designed to minimise currency fluctuations, is manifestly failing to do so. Do currency movements simply pose too great a risk for it to be worth private investors dabbling in foreign markets?

The answer is that it can be worth it, but it depends on how you do it. Around 90 per cent of UK investors have no overseas exposure at all. They take the view that they know too little about foreign markets to make sensible judgements about them and that staying in their home currency is safest.

But overseas investment can actually be a way of diversifying risk in a portfolio so that you are not slavishly dependent on the performance of the UK economy alone. Moreover, if you get it right, the returns from investing overseas can be spectacular: anyone who put their money in the Gartmore Pacific Growth Fund 10 years ago, for instance, would have seen it grow by 628.9 per cent.

It is, though, an area full of caveats. The problem is that you not only have to choose the right markets, you have to get the right currencies, too. Since the Tokyo stock market has moved little in the past five years, Japanese equity investments would have produced fairly poor returns over that time were it not for the fact that the yen has appreciated by some 40 per cent. Most of the return for a UK investor, who would have bought and sold in yen, has been from currency appreciation.

This effect is magnified several times over when it comes to developing countries, where currencies tend to move more wildly. Emerging markets, therefore, represent a far bigger exchange-rate bet. Witness the 50 per cent fall in the peso since December compared with the recent 7 per cent "crisis" devaluation in the peseta.

Since the easiest way to invest abroad is through a unit or investment trust, it is important to know what the policy of the fund is towards currency hedging - in effect, insuring itself against adverse movements of currencies against sterling. Funds that hedge most of the risk will be considerably safer than funds which do not.

Morgan Grenfell Asset Management is one fund manager whose policy is not to hedge. The reason is they consider it too expensive. "In buying a hedge for currency, you're betting that the exchange rates will stand still," said a manager. "It's simply not worth it because if the rates move you are missing out on an opportunity to make money. We like to keep the risk profile of the fund down by not taking on another bet. Hedging is just another risk."

Robert Fleming Asset Managment is at the other end of the spectrum, hedging most of its currency risk as a matter of course. "We actively manage our funds, which means we are actively managing the risk in the funds," says Tim Knowles, manager of the Save & Prosper International Bond Fund (run by Flemings). "That, of course, implies that we hedge currencies to control risk."

The only time Robert Fleming departs from its hedging policy is when it has a positive view in a particular currency, in which case it takes out a deliberate exposure to it. If it expects the yen to rise, for instance, it will not hedge its yen exposure, which would have nullified any benefit from the currency's improvement. "We try to strike a happy medium between having a diversified bond portfolio and a risk-free, fully hedged investment," says Mr Knowles.

As with an unhedged fund, this policy has its dangers. The S&P International Bond Fund, for example, took a bullish view of the dollar recently with the result that it is 40 per cent invested in dollars and only 3 per cent in marks. "Over the last week or so our currency policy has not been right," concedes Mr Knowles, although he continues to believe the dollar will strengthen again later this year.

The S&P fund, however, also has a relatively high exposure to sterling because it measures its performance in terms of the return in sterling. Some funds, however, measure themselves against an international index such as the Salmon Bond Index in which sterling plays little part. These funds may have less than a 10 per cent exposure to sterling. Since they have a higher exposure to foreign currencies, their exchange-rate risk is likely to be considerably higher.

Investors trying to pick an overseas fund should also bear in mind that there is a big difference in the importance that currency risk plays between equity and bond funds.

Equities are, in general, more volatile than bonds. Equity fund managers estimate that share price movements account for 60 to 70 per cent of the risk in their funds. The rest is accounted for by exchange-rate movements.

In bond funds, however, the risk profile is the other way around. Most of the risk is from currency movements while only 30 to 40 per cent is from changing bond prices. In other words, the performance of a bond fund is far more likely to be affected by currency movements than that of an equity fund. Not surprisingly, bond funds are more likely to hedge their currency risk to minimise their overall volatility. It is, however, essential to know how currencies are handled in a bond fund before investing in one.

Finally, the cardinal rule for overseas investment is to take a long- term view. Over five years, currency swings may more or less cancel each other out, making exchange-rate movements a relatively unimportant factor.

But over the shorter term, say a year, the chances of being badly stung are high. It is only the brave who take on the markets at this game.