The Allure of Investing Overseas Must Be Tempered by Forex Exposures

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 |  Includes: DBV, FXE, UDN, UUP
by: Jeff Pierce

The complexion of investing has changed greatly over the past decade as new mediums have grabbed the stage and the barriers to capital flows have been dropped all across the globe.

Capital will always seek out higher returns, even if that means investing overseas. Most every full service broker can now purchase shares for you on nearly every exchange around the world and hold them for you in their respective domestic currency.

Investing overseas also brings into focus another consideration – the possibility that foreign returns might be eliminated if the dollar appreciates materially over your holding period, known commonly as forex risk exposure.

For the past decade, emerging market fund managers have expanded their offerings to meet investor demand, and those enlightened investors that bought in at the millennium crossover have profited enormously from their informed decisions ten years back. Companies in both North America and Europe have been on a cost cutting “binge” for over forty years, engaging primarily in off shoring jobs where low labor and transportation costs provided significant benefits over domestic resource requirements. The result has been an enormous redistribution of wealth across the profile of developing countries, creating prosperous middle classes that wish to live better life styles.

The greenback has been on a bit of a roller coaster ride for the past three years (click to enlarge):

The above chart depicts the weighted index of the dollar versus a basket of foreign currencies. The dollar has appreciated as much as 27% from 2008 to 2009, and then quickly depreciated 17% for the balance of the year. These swings would impact your total return on a foreign investment, helping when it depreciated, and harming when the opposite occurred.

Exchange-traded funds have been the most popular vehicle for U.S. investors to take advantage of this largess overseas. Shares are traded in dollars on domestic exchanges. Fund managers handle the chores of selecting and investing in appropriate securities in foreign lands. These investments are all subject to foreign exchange risk, but performance has been so high that forex impacts have not dampened the enthusiasm. Some fund managers have attempted to hedge the risk with mixed results, since costs rise to cover this process and a weakening dollar diminishes the need for hedging in the first place.

Multinational corporations have currency risk exposures, but their treasury departments are responsible for mitigating any known forex risks, a task that is handled quite well for larger companies with ample resources to fund the effort. Shares in these companies will not fluctuate as much due to these risks as with ETF fund offerings. Small “green” companies that export to Europe, especially Germany where the demand is high for alternative forms of energy, must follow the pricing behavior of the “EUR USD” currency pair to price their contracts appropriately and reduce their forex exposures as well.

“Best practice” for overseas portfolio allocations has generally been 15%, but many feel this figure should be raised to the 25% level due to the long-term trends that are prevalent in the global market place today. Economists expect off shoring to continue and for emerging market economies of the world to outpace advanced economies by multiples of “2X” to “3X” for at least the next two decades.

Investing overseas appears to be a natural outcome due to prevailing international and domestic trends. However, forex risk exposures must also be accommodated with this investing model. Since hedging is far to complex a task for the inexperienced, it may be prudent for investors to time their holding periods when the dollar is weakening to compound returns.

Disclosure: No positions