Role Of Forex In Portfolio Management

Summary

• Investors often under-look the impact of Forex changes on their portfolio returns.
• The USD has depreciated in value of late, and for overseas-based investors buying US equities, this would have hurt their overall returns when they convert back to their home currencies.
• Investors can consider using currency hedges to mitigate the impact of Forex fluctuations on their portfolio returns.

The role and impact of Forex in a portfolio is often under-looked. Investors generally make Forex transactions in order to purchase assets such as equities and bonds. For example, if I were an investor hailing from Europe and I wanted to purchase US equities, I would sell my Euros to buy US Dollars, which will then enable me to buy Apple (AAPL) or Tesla (TSLA) stock.

However, investors may not consider how fluctuations in Forex may impact the overall returns on their portfolio. Appreciation in the investor's home currencies over that of the currencies his/her assets are denominated in will lead to reduced portfolio returns.

For example, using the same scenario as aforementioned, should the investor buy into US dollars from Euros to purchase Apple and Tesla stock, and should both Apple and Tesla stock rise by 20% each, his portfolio would technically enjoy a 20% increase in value. However, what if the investor had sold his Euros to buy US Dollars at 1.05, and the EURUSD exchange rate now stands at 1.15?

The investor would have lost about 8.5% from Forex fluctuations should he liquidate his portfolio and exchange his US Dollars back into Euros, his home currency. As such, the overall portfolio would only be up by 11.5%, or 20% minus 8.5%. This scenario is very real, as EURUSD had just recently moved from 1.05 to 1.15 levels within the past year.

On the flip-side of course, an investor's portfolio returns could also be boosted by favourable Forex movements. For example, a US-based investor might have invested 100% of his portfolio in European equities. Even if the equities have not generated any returns, the investor would have made 8.5% if he/she liquidated the portfolio and switched back into US Dollars from Euros.

Now, given the current market context, how is this relevant to your US-denominated portfolio (I expect most readers here to be primarily interested in US-based equities)? The US Dollar has taken a hit of late against most other currencies, due to a mixture of 1) disappointment over Trump's policies, 2) an increasing number of central banks turning hawkish other than the Federal Reserve, and 3) the Federal Reserve still maintaining a gradual rate hike stance.

Let us take a quick look at the US Dollar Index chart below:

Since the start of the year, the US Dollar Index has fallen from 103.50 to 95 levels, a fall of about 8%. This means the US Dollar has fallen in value against a broad basket of other currencies by about 8%. If an overseas investor bought into US equities at the start of the year, he/she would suffer an 8% loss from Forex changes should the portfolio be liquidated and the cash converted back into his/her home currency. As such, for the investor to make money, the portfolio of equities needs to be up by more than 8%.

Going forward, how can an investor mitigate the impact of Forex changes on portfolio returns? Firstly, it would be ideal if the investor has a use for the currency his assets are denominated in in the first place. For example, if a US-based investor goes on holiday to Europe frequently, or has business dealings there, he/she would have a practical use for Euros. Therefore, he/she would be comfortable holding a Euro-denominated portfolio of assets.

Secondly, an investor could consider putting up a currency hedge. A currency hedge serves to mitigate or reduce the impact of currency movements. An investor who purchases USD-denominated assets would fear the USD depreciating in value. As such, he/she could take up positions that benefit when the USD depreciates in value, to complement his portfolio of US equities.

Such currency-hedging positions include opening up a short USD ETF position such as investing in the PowerShares DB US Dollar Index Bearish Fund (UDN), or opening up a short USD outright position on a Forex trading platform. For example, if a Europe-based investor invests $10,000 in US equities and wants to put up a currency hedge, he/she could open a $10,000 long EURUSD FX trading position on his/her currency trading platform. This hedge would protect him/her from USD depreciation, but at the same time, prevent him/her from enjoying USD appreciation.

At the end of the day, it is important for investors to be aware that portfolio management consists of several facets - choosing the right mix of assets, the suitable underlying positions within each asset class, and also Forex. The impact of Forex changes is often under-looked by the investing community, and it would be beneficial for investors to be aware of how Forex changes can potentially hurt or benefit their overall portfolio returns.

Analyst’s Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.