Will financial advisers be caught out by currency markets in 2017?

<strong>Ben Raven</strong> - Director

Is Sterling undervalued?  Tavistock Wealth believe the fall in the Pound is overdone and the pessimism surrounding the post-Brexit economy is even more exaggerated.

Our Chief Investment Officer, Christopher Peel, references countries such as the US, China and Australia as queuing up to negotiate separate trade agreements with the UK, potentially increasing the demand for the Pound in the future. We believe the UK should retain the vast majority of its trade flow with the EU, given its proximity and the fact that it imports more goods to the continent than it exports. According to Christopher Once the speed and trajectory of the Brexit timeline have been defined, Sterling can easily recover much of the 15-20% that it has lost versus the US Dollar and Euro in the last eighteen months”.

Will 2017 see it rebound?

If Sterling rallied, what would be the impact on financial advisers and their clients?
We know many clients are invested in globally diversified portfolios. If we assume these portfolios contain 50% assets denominated in GBP and 50% assets denominated overseas, this could leave clients, and financial advisers in a precarious position. These clients will expect their portfolio to be impacted by future trade agreements and the health of the UK economy following Brexit. However, they are expecting the impact on their portfolios to come primarily from movements in the equity and bond markets. They expect their returns, and the level of risk they take to generate those returns, to be impacted by ONLY the asset classes listed on the fund factsheet or the marketing literature their adviser has discussed with them.

The asset class that is omitted all too often from these documents, and conversations, is the FOREIGN EXCHANGE MARKET.

In our view, should we experience a successful hard exit from the EU and witness the formal establishment of additional trading partners, Sterling is likely to adopt many of the same robust qualities that have made the Swiss Franc one of the strongest and most stable currencies in the world over the last 25 years. What does this mean for UK retail clients? It means that in a hypothetical environment where financial markets are flat, the overseas half of their portfolio will decrease in value, leading to an unexpected loss for those clients. This is because half of their portfolio is denominated in currencies which will weaken against a rallying Pound.

To many financial advisers, this will seem like an alarming prospect. However, they need only look at the returns generated by their clients in recent years to see how the currency markets have worked in their favour. Numerous retail clients with globally diversified portfolios would see very interesting findings of late if they simply knew where to look.

In our view, should we experience a successful hard exit from the EU and witness the formal establishment of additional trading partners, Sterling is likely to adopt many of the same robust qualities that have made the Swiss Franc one of the strongest and most stable currencies in the world over the last 25 years. What does this mean for UK retail clients? It means that in a hypothetical environment where financial markets are flat, the overseas half of their portfolio will decrease in value, leading to an unexpected loss for those clients. This is because half of their portfolio is denominated in currencies which will weaken against a rallying Pound.

To many financial advisers, this will seem like an alarming prospect. However, they need only look at the returns generated by their clients in recent years to see how the currency markets have worked in their favour. Numerous retail clients with globally diversified portfolios would see very interesting findings of late if they simply knew where to look.

An example for a UK client would work as follows:

A UK retail client holding an unhedged GBP share class of a Japanese equity fund within their globally diversified portfolio over the past 24 months (as of 31/01/17). During a period where the Nikkei 225 Index rose by 7.73% in local currency terms, the UK retail client would have seen the Japanese component of their portfolios make a gain of approximately 27.45%. This is because the Pound has fallen approximately -19.72% vs the Japanese Yen over that same period.

In this example, the client has signed up to an asset allocation that has likely been described as having a global remit and a given level of volatility. Within their portfolio, the client was told they were investing in the Japanese equity market. This holding made the client much more (27.45%) than the underlying investment (7.73%) because it exposed the client to the currency markets, specifically GBP/JPY, potentially without their knowledge or consent.

In this example the client is entitled to keep their gain. However, if the Pound had risen by approximately 7.75% over the 24 month period, the client would have suffered a loss when the Japanese equity market was up. This loss, incurred by taking a type of risk the client was arguably unaware of, could spell trouble for financial advisers and a rally in Sterling could send shockwaves throughout the industry.

The rally may not be prompted by Theresa May’s hard Brexit and it may not take place in 2017. That being said, we know GBP is currently trading at the low end of its historical trading range and anyone recommending globally diversified portfolios to their clients should proceed with caution.

A UK retail client holding an unhedged GBP share class of a Japanese equity fund within their globally diversified portfolio over the past 24 months (as of 31/01/17). During a period where the Nikkei 225 Index rose by 7.73% in local currency terms, the UK retail client would have seen the Japanese component of their portfolios make a gain of approximately 27.45%. This is because the Pound has fallen approximately -19.72% vs the Japanese Yen over that same period.

In this example, the client has signed up to an asset allocation that has likely been described as having a global remit and a given level of volatility. Within their portfolio, the client was told they were investing in the Japanese equity market. This holding made the client much more (27.45%) than the underlying investment (7.73%) because it exposed the client to the currency markets, specifically GBP/JPY, potentially without their knowledge or consent.

In this example the client is entitled to keep their gain. However, if the Pound had risen by approximately 7.75% over the 24 month period, the client would have suffered a loss when the Japanese equity market was up. This loss, incurred by taking a type of risk the client was arguably unaware of, could spell trouble for financial advisers and a rally in Sterling could send shockwaves throughout the industry.

The rally may not be prompted by Theresa May’s hard Brexit and it may not take place in 2017. That being said, we know GBP is currently trading at the low end of its historical trading range and anyone recommending globally diversified portfolios to their clients should proceed with caution.

Conversations around the underlying client portfolio tend to focus on pie charts and headline risk levels. The exclusion of currency risk from the discussion means a client may experience a level of performance they were not expecting and a level of volatility they did not agree to. If the client has been invested in something without fully understanding the risks this could lead to complaints.
When the rally in Sterling does eventually take place, UK retail clients could lose money whilst the underlying investments make gains. Add in the inappropriate levels of risk being taken and a complaint on these grounds will be almost impossible to defend.

This could be the next scandal in UK financial services.

This investment Blog is published and provided for informational purposes only. The information in the Blog constitutes the author’s own opinions. None of the information contained in the Blog constitutes a recommendation that any particular investment strategy is suitable for any specific person.

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