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The appreciation of the British Pound (GBP) should bring smiles to the faces of many UK investors and consumers. UK-based gold ETF investors, however, may be in for quite a shock.

Many of the physical gold exchange-traded funds (ETFs) that investors have flocked into over the last year don’t hedge against movements between GBP and the US Dollars (USD) they use to buy the metal. Investors have reaped benefits to date but with GBP appreciation on the horizon, they may risk losing over a year’s worth of gains if they remain exposed to currency movements.

Because the gold price is denominated in USD, physical gold funds must convert investors’ GBP, Euros or Swiss Francs (CHF) before purchasing bullion. More often than not, these funds convert currencies without a forward contract or other hedge to neutralise foreign exchange (FX) rate movements, leaving investors exposed to this market and holding risks beyond those posed by the gold market.

FX rates can have a bigger effect on physical gold investments than many ETF investors actually realise. For example, an investor who redeemed $1,240 worth of a gold bullion investment on 1 June 2010 would have received £855 (minus fees) (Financial Times market data). On 1 June 2008, when the GBP-USD rate was $1.96, this would have only translated to £632.

Fortunately, this exposure has paid off for UK investors in the last 12-16 months as the GBP depreciated against the USD by 12% (Bloomberg). Add this to the 30+% increase in the price of gold and this equals an admirable 42+% return for investors over the last year.

However, we’re all aware that what goes up must come down. As soon as the GBP appreciates, the opposite effect will occur. Investors may see the value of their investments drop as their USD translates into less GBP.

Time may be running out

This time may be coming sooner than investors think. In our opinion, the GBP is currently undervalued by 12% to 15% against the USD and there are plenty of signs pointing to an imminent bounceback. The UK has already gone through its share of economic shocks – Northern Rock, for example – and started putting the appropriate austerity measures into place. In our opinion, the UK has been at the forefront of global currency depreciation and should likely lead the pack when it comes to appreciation.

The UK is a strong manufacturing nation and, with GBP at the $1.47 to $1.50 level, exports look very attractive. A growing demand for exports, as well as recent austerity measures put in place as part of the June emergency budget, could instil market confidence and push the GBP up to $1.65 in the short-to-medium term.

Can gold fund investors retain their gains?

Of course – it’s as simple as getting rid of the currency exposure. One option is to simply cash out while you’re ahead. For investors that want to retain their exposure to gold, there are offshore funds that offer share classes in multiple currencies and hedge out the FX movements.

Funds that use currency hedges ensure that the investment performance is as closely linked as possible to the underlying gold price. These funds also enable investors to retain exposure to ‘real’ assets in the same currency as the other holdings of their portfolio, whether it’s GBP, USD or Euro.

In our opinion, the longer UK-based gold fund investors stay in unhedged positions, the more they stand to lose. In just under a month, the GBP-USD rate has risen five cents to $1.50. How many hard-earned gains are investors willing to part with?