Industry commentators have warned the majority of independent financial advisers (IFAs) and wealth managers have failed to hedge their foreign currency holdings into sterling, meaning a rally in the pound could wipe out returns.
In a further warning, they said unknowing investors in safe-haven assets such as global bond funds will be hardest hit by a sterling rally, as bonds are most affected by currency movements.
In 2016, investors in foreign assets benefitted from a sterling windfall following the collapse in the currency after the UK voted to leave the European Union (EU). The pound plummeted 16.5% against the dollar to as low as $1.149 during that year, fuelling the rise of foreign equity holdings and large-cap UK stocks.
However, according to Christopher Peel, CIO of Tavistock Wealth, this trend is set to reverse after the UK leaves the EU next year, even if the Withdrawal Agreement is rejected and the UK moves towards a no-deal scenario.
We systematically hedge safe assets such as government and corporate bonds, but we do not tend to hedge equities as most of the equity risk comes from equity volatility – Sleep
If the UK agrees a deal with Brussels, Peel said sterling could rally beyond $1.50, which would lead to massive losses for investors who have failed to hedge their non-UK-domiciled assets.
"When this gets unwound there will be nowhere to hide," Peel warned. "The fall in sterling over the last decade has masked core investment selections by fund managers as they have enjoyed the majority of their returns from this decline."
He added the investment industry has failed to fully disclose this risk to clients, who may not be aware their sterling exposure is at record lows.
"This is the next big scandal to hit the UK market, but it will take huge losses for anything to change," he warned.
Peel claimed the Financial Conduct Authority (FCA) was aware of the issue but lacked
"the firepower to address [it]", while also blaming the Investment Association for its failure to categorise hedged and unhedged funds.
"The FCA has turned a blind eye and is just hoping for the best. There will be class action suits; it will be a field day for law firms," he said.
"I have no sympathy for anyone in the industry who has ignored the FX exposure within client portfolios. Most fund management companies do not hedge as they do not have the expertise or do not have the credit facility in place to facilitate the forward trades. It will come home to roost by the end of the year."
However, many investment firms are waking up to the impact currency fluctuations can have on returns. Earlier this year, PIMCO claimed the US was in a "cold currency war" with Europe, and as a result hedging is now a crucial part of its investment process.
Geraldine Sundstrom, managing director and portfolio manager at PIMCO, said: "It is the first time in my career where FX has such a deep impact on asset selection.
"The world is very global, companies are more integrated than before and FX will have an immense impact on the profitability of companies but also the response function of central banks."
Meanwhile, Peter Sleep, senior investment manager at 7IM, noted a rally in sterling was one of the biggest risks in his portfolios.
Sleep has a number of currency hedges in place to protect portfolios, including forward foreign currency contracts and sterling options.
"We systematically hedge safe assets such as government and corporate bonds, but we do not tend to hedge equities as most of the equity risk comes from equity volatility and not currency," he added.
For example, so far this year to 14 November, the S&P 500 has returned 10.2% versus 0.3% for the S&P 500 hedged to euro while in 2017, the S&P 500 jumped just 7% versus 18.7% for the euro-hedged version, according to Thomson Reuters Lipper.
In a white paper titled The Currency-Hedging Dilemma, Morningstar said there were a number of important factors to take into account when choosing a hedging strategy, including price.
"The costs associated with a hedged strategy are an important consideration because they are a direct drag on future performance and therefore place a price tag on the volatility reduction that hedging can deliver," said Daniel Sotiroff, analyst at Morningstar and author of the report.
However, Eric Wiegand, head of ETF strategy at DWS, said there were a number of other factors to consider in a hedged ETF strategy, including the benchmark and the methodology.
Wiegand explained each strategy either hedges statically or dynamically. A monthly static strategy means the index rolls the FX hedge on a monthly basis, but this opens up the fund to large swings in the currency intra-month, which can lead to return fluctuations.
A dynamic hedge, he said, allows the fund manager to set a threshold of, for example, 1%, meaning if the currency swings by more than 1% the hedge adjusts.
"A dynamic hedge is dependent on the market movement," he said. "This is the best compromise in terms of cost and reducing FX volatility and exposure.
"There is also the option to statically hedge every day," he continued. "However, this is not ideal because rolling your forward every time is sometimes unnecessary and costly," Wiegand added.