The general public has a broad misunderstanding and mistrust of the finance industry. Some of that is entirely deserved – it has had its fair share of scandals and blow-ups over the years. But too many people form their view of how markets work from Hollywood. So if they’ve been brought up with Trading Places or Wall Street, or more recently the Wolf of Wall Street or Billions, then they’re going to have a very colourful view of the world of finance.
The truth, of course, is considerably less exciting than the glamorous, greedy and grotesque world inhabited by Gordon Gekko, Louis Winthrope III or Bobby Axelrod.
Misinformation is a plague on our industry. Not deliberate distortion of facts, but rather vague writing, assumptions of knowledge and a lack of clarity when it comes to jargon. Of all the misunderstood terms in the financial lexicon, ‘hedging’ is among the worst. Often confused with hedge funds (and all the perceptions that come with that expression), these two terms couldn’t be further removed from each other.
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 reality is that hedging is an investment technique with several important uses that are absolutely relevant to all of us today.
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.
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 hedging could be 2017’s word of the year
The British pound is not the stable currency we’ve become used to. Since the Brexit vote, it’s fallen a lot, particularly against the dollar. And Donald Trump’s election is expected to herald more dollar-positive policies. Not good news for British holidaymakers or people buying goods from abroad.
But the fall in the pound has actually been good news for those who have had their money in overseas investment funds. 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 (if) the pound does rise again, overseas investments would be negatively affected.
Now this is where hedging comes in. More fund managers are now promoting investment funds with ‘hedged share classes’. Essentially, they are the same as your regular investment fund in that they give you exposure to overseas markets. The difference is they use hedging to remove the currency risk. These hedged (note, not hedge) 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 the pros and cons are.
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.