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The Effect of Currency on International Returns

My wife and I took a cruise through Europe in the fall of 2013 along the Mediterranean. As we arrived at different ports and visited various cities along the sea, I was floored by how little my dollar went overseas. With a foreign exchange (FX) rate of about $1.40/€, enjoying a €5 gelato while walking the streets of Florence was a $7 experience. Secretly, I hoped to return overseas at a different time when my dollar would go further.

Fast forward to the end of 2016 and the Euro is trading near a 14-year low relative to the USD. Next time I visit Europe I can have the satisfaction of knowing my dollar can go 25% further. It’s almost like everything there is on a 25%-off sale. My $4,500 budget for spending onshore can go as far as $6,000 went in 2013, and I can purchase some gelato at $5.25 instead of the $7 it originally cost and the local vendor is none the wiser.

[pullquote]However, while tourists dream of seeing the value of their dollar go further overseas, that doesn’t come without a price.[/pullquote]

However, while tourists dream of seeing the value of their dollar go further overseas, that doesn’t come without a price. As it turns out, U.S. Investors are exposed to one extra layer of risk when investing internationally: Currency risk. Currency risk is risk that arises from changes in the relative valuation of currencies. So as you order gelato in Italy at 25% off in USD, you will also be “enjoying” that same lower 25% value of your international stock holdings of, say, BP, Nestle, or Novartis.

Reality Check on International Exposure

As I logged into my 401k account, I reviewed my year-end balances for 2016. With most major indices worldwide up 10% for 2016, such as the UK Stock Market FTSE 100 (+~17%), Japan’s Nikkei (+~7%) and German DAX (+~11.5%), I expected to see my international exposure up about 10%. What did I find instead? My international holdings were up only 3% for the year! If the funds in my account are designed to be made up of stocks in these international indices that have been up nearly double digits, why were my returns not following along?

Currency Effect’s Impact on International Goods

To explain this, let’s imagine that I lived in the UK and to kick off 2016, I purchased shares of BP (a USD investor can buy a single BP ADR, which represents six BP local shares in London). In January 2016, I could have purchased six shares for £21.24, and at year end, the company’s shares would be at £30.576 – a wonderful one-year return of nearly 44%, not including dividends. Because I live in the United States, however, and my returns are denominated in dollars, I would have purchased those same shares with $31.26 and seen the shares rise to only $37.38 through the same date – a return of +19.6%, which is a difference of 24.4% for the year. This difference was driven entirely by currency, thanks in large part to the results of the Brexit referendum driving the British Pound to multi-decade lows.

Hedging Helps Mitigate Risk

So, why am I cheering for less expensive international goods at the expense of my investment accounts?

Using December 31, 2016, as an end date, over the previous five years, the effects of currency movements on USD returns detracted against performance by 5.32% per year over that time. As a USD investor, my international holdings were up 6.07% annualized over the last five years while a local currency investor would have enjoyed returns of 11.39%. Had a USD investor purchased a currency-hedged product, they would have enjoyed those 11.39% returns.

But if you look at the previous five years before that, currency effects benefited performance by nearly 2% per year over the time. Over the five years prior to that, it added over 6.5% per year.

Table of Returns*

Time Horizon Local Currency Returns USD Returns Currency Effect
2011-2016 11.39% 6.07% -5.32%
2006-2011 -6.04% -4.09% 1.95%
2001-2006 8.72% 15.25% 6.53%
A strengthening dollar detracts against USD returns; a weakening dollar adds to USD returns

With the U.S. dollar at a cyclical high, perhaps I could try to mitigate my currency risk through a currency hedged fund. That way, for example, if the UK stock market goes up 10%, my portfolio will go up 10%. But locking in today with the U.S. dollar near a 14-year high is essentially locking in with the value of your international securities at a 14-year low.

What You Can Do

No one will ring a bell at the top of the USD strength and no one will ring a bell at the bottom. So what can an investor with a long-time horizon to do? Investors can continue on the same path of investing in international holdings, since the strength of the U.S. dollar is cyclical, appreciating and depreciating over time, as has been very evident over the last 15 years. Oh, yes, and one more thing: for those who invest internationally, cheer for even more expensive vacations abroad.

*5 year returns over three time periods of U.S. and Local Index Returns based on the MSCI World Ex U.S. Net Index

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