Taming the wolf: hedging explained
If your understanding of the stock market is still based on 1980s movies like Trading Places or Wall Street, then you probably have a certain view of financial markets.
Modern day film and television is little better, with Leonard di Caprio’s Wolf of Wall Street and Damian Lewis’s Billions presenting a grotesque interpretation of how finance works.
The reality is that hedging is an investment technique with several important uses that are absolutely relevant to all of us today.
Thanks largely to Hollywood, hedging is unfairly associated with hedge funds. While hedge funds are known for high-risk speculation on shares, commodities or pork belly futures, hedging is actually a technique designed to decrease risk.
The use of ‘hedge’ as a verb goes back to the 1590s and was first used in the 1670s in the context of insuring yourself against a loss (source: Wikipedia).
Farmers effectively invented futures and options contracts with their buyers to agree the price at which they will sell their crops later in the year. They did this (and still do today) to protect themselves from the risk of the price falling before their crop is harvested.
In the modern world, futures and options are used in all sorts of ways to hedge risk. A life insurance policy protects your family by paying off your mortgage if you die. When you buy a fixed-price deal for your gas or electricity, your utility company is using a hedging strategy to create your price.
And many people living in countries with unstable economies keep some of their cash in dollars or euros just in case their home currency falls.
Why Brexit and Trump means you need to think about hedging
You may be using hedging already, perhaps to cover currency fluctuations relating to your company’s exports, or maybe for your personal investments. But if not, then you might want to look into it or get some advice. Here’s the issue:
The British pound is not the stable currency we’ve become used to in the past decade or so. Since the Brexit vote, it has fallen sharply against most other currencies. And Donald Trump’s election is expected to bring policies that will strengthen the US dollar even further.
The fall in the pound has actually been good news for those who have had their money in overseas investment funds – as long as they haven’t been hedging the currency risk. For example, the US stock market went up by 12% in 2016. But UK investors benefited from the weak pound when that return is converted back into sterling; their return was over 33%.
The question most financial experts are considering is how low the pound could go. But those same experts are also thinking about when the tide might turn again. The issue, of course, is that when the pound does rise, overseas investments would be negatively affected.
That’s where hedging comes in. Most fund managers now offer savers investment funds with ‘hedged share classes’.
Essentially, they are the same as your normal investment fund in that they let you invest in overseas markets.
The difference is they use hedging to remove most of the currency risk. These funds work in investors’ favour if the pound goes up (because they’re not hit by the currency movements).
But if the pound gets weaker, UK investors miss out some extra gains from the currency moves.
The Telegraph has published a neat article about how these hedged share classes work and what you need to think about. And a financial adviser can help you get your head around what’s right for you.
I think it’s safe to say Hollywood may never make a blockbuster movie about hedging. Let’s be honest, insurance is few people’s idea of gripping entertainment!
But then again, when people’s savings are at risk, maybe a lack of excitement is a good thing.
Niels Footman is Head of Marketing at Copylab, an international communications agency based in Scotland.
Want to read more about copywriting, jargonbusting and marketing communication? Check out Copylab’s blog