What You Should Know About Currency Risk

Currency effects on investments are important and probably not appreciated enough by most investors.

If you have a conviction about the direction of the US Dollar, you can power boost your general equity returns by exposing your portfolio more or less to domestic or foreign stocks. If you don’t have a conviction, you are still likely making a currency bet, when you chose your balance of domestic and foreign stocks or stock funds.

Analyzing the results of a multi-company foreign index from the top down can give a fairly clear view of the effect of currencies on index performance, as the table below shows.

The 3, 5 10 and 15 year annualized returns of the Russell 1000 (IWB) is shown in US Dollars. The MSCI World ex US (VEU), the MSCI EAFE (EFA), the MSCI Europe (IEV) and the MSCI Japan (EWJ) indices are shown for the same periods in both US Dollar denominated returns and in local currency denominated returns – all but Japan involve multiple currencies weighted according to the weight of each country in the index.

The difference between the US Dollar denominated return and the local currency denominated return measures the effect of currency exchange rate changes from the perspective of US Dollar based investors.

For example, the table shows that the return experienced by US investors who invested in the developed and emerging markets of the world excluding the United States should attribute ¼ to ½ of their return to currency effect – the decline of the US Dollar against those other currencies in this case.

You can also see that the relative strength of the US Dollar depressed the Dollar denominated returns of EAFE investments over 10 and 15 years, and over 3 years for Japan investments.

Let’s flip it around now and see how investors based in other currencies experienced returns investing in the United States, as exemplified by the Russell 1000 (the largest 1,000 U.S. public companies).

You can see that developed world, non-US Dollar investors did better in the U.S markets over a 10 and 15 year period due to a rising Dollar. They did less well over 3 and 5 years due to a falling Dollar. Only the Japanese, in these examples, have benefited by currency effects during the past 3 years when investing in the U.S. stock market.

On average U.S. investors and foreign investors have done better recently by investing outside of the United States. A significant part of the that benefit comes from growing relative strength of other currencies.

There are products that allow investors to take direct currency exposure such as futures accounts, FX accounts, and a growing number of currency ETFs and ETNs (such as (UUP), (UDN) to bet on the direction of the Dollar against a trade weighted basked of currencies; (FXE) and (ERO) to hold the EURO; and (FXY) and (JYN) to hold the Japanese Yen), but few investors would commit large allocations to those products. Yet, investors make large currency related allocations, often unknowingly, when they decide how much of their equity portfolio will be in US stocks versus foreign stocks.

You really need to consider the currency issue when you design your portfolio holdings and allocations.