After you have had that second cup of coffee or tea, find your brokerage or 401(k) statement and check to see whether your investments in foreign stocks made money last year.
Actually, I can save you a bit of time. Most diversified foreign stock portfolios lost somewhere between 2 and 6 percent last year, even though most stock markets posted gains in 2014. What happened? In a word, currency. Two weeks ago I spent some time discussing credit risk. This week I want to talk about currency risk in your investment portfolio.
For the past 35 years, financial advisers and money managers have encouraged us to diversify our holdings by investing in portfolios of overseas stocks and bonds. The trend began in the 1980s as advisers encouraged us to invest in large companies in Europe and Asia. In due course, we were urged to put some money into emerging market stocks as well as investment grade foreign bonds. In the past 10 years, emerging market bonds were added to list of appropriate investments. On the whole this has been sound advice.
Over the years, many investors have put 25 percent or more of their investments into overseas mutual funds, exchange-traded funds (ETFs) and depository receipts (DRs). A DR is a stock holding in a foreign company listed on a U.S. exchange. While most investors have come to understand the risks of the stock and bond market, they’ve failed to appreciate the role of currency in determining their investment returns. If you are short-term-oriented, the gyrations of the dollar against other currencies can play havoc with your investment returns and with your emotions.
For example, in 2014 the developed foreign markets (measured by the MSCI EAFE index) returned 5.7 percent and 16.3 percent for one and three years expressed in their local currencies (euros, yens, pounds, etc.). However, as Americans we invest in dollars, so we translate those foreign currencies back into U.S. currency to calculate our returns. As a result, the gains in most foreign stock markets were reported to us as a loss of 4.9 percent and a gain of 11.1 percent for the past one and three years. In other words, developed markets enjoyed a bull market in local current terms, rising 16.3 percent from 2012 to 2014. However, the strengthening dollar sapped 5.2 percent per year from our three-year return translated back into dollars.
For those of you with a small investment overseas and a long-term perspective, the remainder of this column isn’t going to be very important. Year-to-year currency fluctuations won’t have an appreciable effect on the short-term results of your overall portfolio, and over a decade or more the rise and fall of the dollar will even itself out. However, the rest of us had better understand the role of the dollar and foreign currencies in our portfolios.
Let’s begin with the basic mechanics of foreign currency. If you invest in overseas securities, during any time period in which the dollar strengthens, a portion of your investment return will be drained away because it takes more euros, yen or pounds to convert your investment back into dollars and calculate your return. For example, if you invest in a stock denominated in euros when one dollar buys 1.3 euros, and then after a year those 1.3 euros are only worth 92 cents, your financial statement would show an 8 percent loss, assuming underlying stock didn’t go up or down during the year. Conversely, if the dollar weakens during the same period, your return would be boosted as a stronger foreign currency (weaker dollar) translates into more dollars.
In a diverse portfolio, the currency swings will simply add or subtract a few percentage points to your returns. However, if you make a concentrated bet in the stocks or bonds of a single country, you can experience a wild ride, as any investor will tell you if they have been to exposed to the Russian ruble or Argentinian peso in the past couple of years.
In my experience, financial advisers tend to recommend four strategies for dealing with foreign currency risk. Two of these methods tend to mask the risk, while two address the risk, albeit at a cost. Often advisers will recommend investments in depository receipts. You can buy a wide variety of European, Asian and Latin American stocks that also trade on the New York or another American stock exchange as DRs.
Because the investment is in dollars, it appears that you don’t have exposure to foreign currency. However, that’s just a mirage. If the foreign company’s home currency weakens (the dollar strengthens), the DR price is going to reflect that weakness. If the stock didn’t weaken, hedge funds would have a field day shorting the DR, hedging the currency and buying the stock in its home currency. A depository receipt is a reasonable way to invest in foreign securities, but it doesn’t address currency risk.
In the world of fixed income, some foreign companies and governments issue dollar-denominated bonds. Even though their business makes profits (or government collects taxes) in Turkish lira or Brazilian real, they owe their bondholders in dollars. If the lira or real weakens, the company still owes the same amount in dollars. It appears that American investors will get their interest and principal back no matter what happens to the local currency. However, if the company’s or government’s home currency falls sharply, the company or government may not have enough liras or reals to meet the escalating cost of funding their debt and interest payments in dollars. Even though your foreign bond portfolio is denominated in dollars, your returns are likely to suffer because some of the price of the bonds will decline in order to reflect the increased probability that the company or government may default.
Hedge the risk
To deal with the problem of currency risk, an increasing number of funds offer to hedge the risk. This is done by continually purchasing enough currency futures contracts to ensure that all the positions can be converted back into dollars at the current exchange rate. While currency hedging offers peace of mind, the strategy carries a substantial price to investors. Continuously buying future contracts doesn’t come cheaply. Someone (usually a bank) has to be paid for assuming the currency risk. Moreover, during those periods when the dollar is weak, the hedges will shield the portfolio from gains that would have been generated by a cheapening dollar.
Not surprisingly, Wall Street has an answer to the high cost of permanently hedging currency risk. Some mutual funds offer to hedge currency only in situations where the dollar is likely to rise, which is called tactical hedging. Tactical currency hedging would be a great benefit if anyone possessed a crystal ball and could accurately predict the rise (hedge) and fall (don’t hedge) of the dollar. Unfortunately, currency traders aren’t any better than stock pickers, so tactical hedging seldom works.
In the end, the best strategy is to limit the amount of foreign currency exposure in your portfolio. It’s important to remember that the liability you are trying to fund, whether it’s retirement or college savings, is denominated in dollars. As a result, you want the vast majority of your assets to be in the same currency as your liabilities.
If your exposure to foreign stocks and bonds is no more than about 20 to 25 percent and your investment horizon is a decade or more, there’s not much reason to worry about your exposure to foreign currency. Although the strong dollar might nick your portfolio by 1 or 2 percent over a period of a couple of years, a weaker dollar will likely benefit the portfolio at some point in the long run.
Foreign investment is good for your portfolio when it’s done in moderation. If it’s done to excess, your portfolio is likely to suffer, the currency fluctuations will unsettle you, and your financial adviser, money managers and brokers will be very happy earning excessive fees and commissions, and trading profits.
Andrew Silton’s Meditations on Money columns can be found twice a month in The N&O’s Work&Money section. He is a retired money manager living in Chapel Hill. He was CIO for the North Carolina Retirement System from 2002-2005. He writes the blog http://meditationonmoneymanagement.blogspot.com/