How Currency Moves Can Affect Your Investments

Adviser Eric Weigel says investors often forget that when the U.S. dollar is strong, their investments in international assets could take a hit through currency losses.
By Retirement Daily Guest Contributor ,

By Eric J. Weigel

The case for international investing is often made based on the diversification potential of combining asset classes that don't move in total sync. Technically speaking, people often use correlations as a way to assess the diversification potential of an asset class. Diversification is good because it lowers the overall volatility of a portfolio.

People also care (a lot) about returns. In the early days of international investing (the '70s and '80s) the case was often made that investing outside of the U.S. would yield higher returns because these markets were less developed and their economies were outperforming. For those of you old enough, do you remember when Japanese corporations were taking over the world and Japanese stocks were going through the roof?

In the years since, both institutional as well as individual investors have significantly ramped up their allocation to international assets. The debate used to be whether to invest in international assets at all. Today the debate is much more about how much to allocate to international equity and bond markets.

Many companies today operate across a multitude of global markets, both in end-markets as well as in their supply chains. We no longer call these companies multinationals -- they are really just part of the new globally integrated economic system.

Does it matter that Novartis is based in Switzerland and Daimler Benz in Germany? What about Toyota and Sony being based in Japan? All these companies sell, finance, and source their business across dozens, if not hundreds, of countries.

Large and small businesses are most often globally integrated. Companies are slugging it out everywhere regardless of where they are domiciled.

If companies are globally integrated, does it even make sense to split the equity allocation into U.S. and international strategies?

On the surface the answer appears to be no. All stocks should be treated as coming from a gigantic global bucket. After all, stocks are exposed to similar types of risks whether they are based in China or Spain - economic growth, the cost and availability of credit, inflationary pressures and investor sentiment.

But when you dig a bit deeper there are some material differences depending on the country of domicile. First, the most obvious ones: regulatory, tax and trade policies. OK, that makes the job of the fundamental analyst more difficult as company valuation now needs to take into account these country-specific idiosyncrasies.

Another large difference is currency.

This is a big one often ignored by investors.

The tendency among investors is to look at returns on international assets in their base currency. So, U.S. investors look at everything in U.S. dollars. British investors look at everything in terms of British pounds and so on. In fact, I do not recall one fund marketing brochure that does not present returns from the perspective of the domicile of the investor.

Let's focus on investors living in the U.S.

Let me ask you, does looking at index or fund returns of an international investment in U.S. dollars make sense? Probably yes, as the U.S. investor most likely cares about his/her spending power on U.S. soil.

But there is another perspective that needs to be explored. Once you have made the investment what you get is a package of local asset returns (say the return on Sony in yen) plus the change in the value of the local currency relative to the U.S. dollar. But what about before you make the investment?

Does it make sense to evaluate whether to make the investment in an international strategy in the first place based on just looking at asset returns expressed in U.S. dollars?

Here the answer is a bit more complicated.

An investment in a foreign stock or an international index fund is a function of two things:

  • The return in local currency (yen for a Japanese company) and,
  • The currency translation into the U.S. dollar (for a Japanese company this would be the change in the yen/USD value)

How well did an investment in a basket of Japanese stocks do over the past year? Using the MSCI Japan index as a representative investment, the return was 6.93% to Japanese investors as of Sept. 28, 2018. To you based, in the U.S., the return was 6.21%.

Why the discrepancy? Remember that your return sitting in the U.S. is a combination of how well the investment did in yen as well as the yen to USD currency translation. In this case, you as a U.S.-based investor lost 0.72% due to the strength of the U.S. dollar.

Investors often forget that when the U.S. dollar is strong (appreciating) their investments in international assets will take a hit through currency losses.

Conversely, if the U.S. dollar is weak (depreciating) their returns on non-U.S. assets will benefit positively from currency gains.

OK, you win some, you lose some, and in the end, it evens out, right? You may think that losing 0.72% due to currency is no big deal.

But what if you had invested in a basket of Brazilian stocks because you thought that they were beaten down and inexpensive? A basket of stocks identical to the MSCI Brazil index would have gained 6.90% in Brazilian reals.

Not bad, but why did your brokerage statements at Fidelity show a -0.6% return to the investment over the past year? Is this a mistake? No. The answer lies in the currency effect.

Over the past year, the Brazilian real has depreciated 7.5% versus the U.S. dollar. Your 6.9% return has shrunk to a slight loss. Ouch! Did you even know you had invested in both Brazilian stocks and the currency?

Most investors do not break out their U.S. dollar return from its underlying currency. Local currency asset returns and the associated currency translation are two distinct and separate sources of return.

If you invest in a vehicle that is expressed in U.S. dollars (for example, the iShares MSCI Brazil ETF EWZ on the Brazilian equity market) you are getting the package of equity market returns and currency. You cannot get one without the other.

What about international investing over longer periods of time?

People often assume that the currency effect washes away.

Not that October 2008 brings any great joy to anybody, but let's look at how global equity markets have done over the past 10 years. We present equity index data from MSCI as of the end of September 2018, for a compilation of 47 equity markets.

We are going to look at U.S. dollar returns as well as the breakdown between index returns in their native currency and the effect of currency translation.

Let's start with U.S. dollar returns because, after all, this is the perspective that most often influences how much investors allocate to international equities.

If returns to international markets exceed those from U.S. stocks, investors tend to believe that the decision was wise. If they underperform, they infer that their decision was poor.

MSCI Index

USD RETURNS

THAILAND

14.00%

USA

11.98%

NEW ZEALAND

10.81%

TAIWAN

10.79%

PHILIPPINES

10.50%

HONG KONG

10.43%

DENMARK

10.04%

PERU

9.66%

SWEDEN

9.62%

CHINA

8.50%

KOREA

8.27%

INDONESIA

8.21%

SWITZERLAND

8.19%

NETHERLANDS

7.92%

BELGIUM

6.92%

SINGAPORE

6.88%

AUSTRALIA

6.87%

MALAYSIA

6.68%

INDIA

6.53%

JAPAN

6.21%

FRANCE

5.87%

PAKISTAN

5.74%

GERMANY

5.67%

SOUTH AFRICA

5.54%

FINLAND

5.48%

NORWAY

5.44%

COLOMBIA

5.21%

UNITED KINGDOM

4.98%

QATAR

4.35%

CHILE

4.04%

CANADA

3.99%

MEXICO

3.16%

UNITED ARAB EMIRATES

1.70%

ISRAEL

1.61%

IRELAND

1.44%

RUSSIA

1.42%

SPAIN

1.07%

HUNGARY

0.88%

AUSTRIA

0.15%

POLAND

-0.54%

BRAZIL

-0.60%

ITALY

-0.63%

CZECH REPUBLIC

-0.80%

PORTUGAL

-2.19%

EGYPT

-2.32%

TURKEY

-3.60%

GREECE

-26.02%

Source: MSCI

What do the past 10 years show in terms of international equity market performance?

For one, investing in U.S. equities would have been best. Only the Thai equity index out-performed the U.S. index.

Investing in the MSCI U.S. Index would have returned a whisker shy of 12% per year over the past 10 years. Investing in the MSCI Thailand index would have yielded an annualized return in US dollars of 14%.

What about the performance of major markets such as Japan, U.K., and Germany? These markets returned (in U.S. dollars) 6.21%, 4.98%, and 5.67%, respectively. Not great, but much better than investing in Greece and losing an annualized 26% over this past decade.

Staying home would have worked best for U.S. investors. Going international hurt performance from a relative standpoint.

What about if you looked at global equity markets without the currency effect?

The below table gives you a look. Thai equities retain the top slot, but U.S. equities are no longer the runner-up. U.S. equities have now fallen to the seventh slot. Not too bad in the context of an entry field of 47 countries.

The relative rankings among equity markets have moved around. Swiss equities jumped from 16th from the bottom to 13th from the top. The appreciation of the Swiss franc relative to the U.S. dollar over the last decade is responsible for this. Currency can often muddle up the rankings depending on home country perspective.

MSCI Index

LOCAL CURRENCY RETURNS

THAILAND

13.48%

INDONESIA

13.28%

TURKEY

12.59%

SWEDEN

12.32%

DENMARK

12.15%

PHILIPPINES

12.04%

USA

11.98%

SOUTH AFRICA

11.35%

INDIA

11.25%

NEW ZEALAND

10.89%

PAKISTAN

10.74%

HONG KONG

10.51%

TAIWAN

10.21%

NETHERLANDS

10.05%

EGYPT

9.82%

PERU

9.68%

BELGIUM

8.97%

NORWAY

8.87%

MEXICO

8.79%

MALAYSIA

8.66%

CHINA

8.57%

COLOMBIA

8.50%

UNITED KINGDOM

8.31%

FRANCE

7.91%

AUSTRALIA

7.80%

GERMANY

7.70%

FINLAND

7.50%

RUSSIA

7.46%

KOREA

7.36%

JAPAN

6.93%

BRAZIL

6.90%

SWITZERLAND

6.70%

SINGAPORE

6.38%

CANADA

6.05%

CHILE

5.92%

HUNGARY

5.85%

QATAR

4.35%

POLAND

3.76%

IRELAND

3.39%

SPAIN

3.01%

ISRAEL

2.41%

AUSTRIA

2.07%

UNITED ARAB EMIRATES

1.70%

CZECH REPUBLIC

1.61%

ITALY

1.27%

PORTUGAL

-0.31%

GREECE

-24.60%

Source: MSCI

How big of a deal is currency when investing in international assets?

Capital markets are incredibly fickle. Just when you think that you have figured it out, things change. Currencies are no exception.

The past 10 years have been wonderful from an investment perspective if you invested in U.S. denominated assets. If you invested a significant percentage of your portfolio in non-U.S. equities you are probably wondering about the quality of your decision making.

The below table isolates the annualized 10-year currency returns for the top 47 equity markets around the world. Many of these numbers do not appear that large but remember that these numbers compound to large numbers over a decade.

Investors today fret about paying any expenses on their portfolio. ETFs are regularly evaluated based on their expense ratio. The lower the better. But what investors don't realize is that by focusing on certain direct expenses they are missing the forest for its trees. In the case of international investing, investors are often missing the significance of currency returns.

MSCI Index

CURRENCY RETURNS

SWITZERLAND

1.49%

KOREA

0.91%

TAIWAN

0.58%

THAILAND

0.52%

SINGAPORE

0.50%

USA

0.00%

QATAR

0.00%

UNITED ARAB EMIRATES

0.00%

PERU

-0.02%

CHINA

-0.07%

HONG KONG

-0.08%

NEW ZEALAND

-0.08%

JAPAN

-0.72%

ISRAEL

-0.80%

AUSTRALIA

-0.93%

GREECE

-1.42%

PHILIPPINES

-1.54%

PORTUGAL

-1.88%

CHILE

-1.88%

ITALY

-1.90%

AUSTRIA

-1.92%

SPAIN

-1.94%

IRELAND

-1.95%

MALAYSIA

-1.98%

FINLAND

-2.02%

GERMANY

-2.03%

FRANCE

-2.04%

BELGIUM

-2.05%

CANADA

-2.06%

DENMARK

-2.11%

NETHERLANDS

-2.13%

CZECH REPUBLIC

-2.41%

SWEDEN

-2.70%

COLOMBIA

-3.29%

UNITED KINGDOM

-3.33%

NORWAY

-3.43%

POLAND

-4.30%

INDIA

-4.72%

HUNGARY

-4.97%

PAKISTAN

-5.00%

INDONESIA

-5.07%

MEXICO

-5.63%

SOUTH AFRICA

-5.81%

RUSSIA

-6.04%

BRAZIL

-7.50%

EGYPT

-12.14%

TURKEY

-16.19%

Source: MSCI

You may wish that currency returns washed away but at least over recent modern history currency returns can often prove to be significant contributors of return.

For example, U.S.-based investors in the MSCI EAFE index (developed markets) would have lost 1.33% per year to currency. For emerging market investors the situation is even worse at an annual loss of 2.32% per year. The compounding effect of these currency losses is huge.

Should investors just focus on the U.S. market and ignore international markets?

The answer is no, no, no. Just because over the last 10 years U.S. markets vastly outperformed most other global equity markets does not mean that this will persist over the next decade.

Capital markets are ever-changing and often mean revert. What is up often ends up being down at some point in the future.

International markets offer diversification benefits to an all-U.S. equity portfolio. Correlations between domestic and international assets run between 0.8 and 0.9. Adding international assets to a domestic equity portfolio will, under most circumstances, lower the volatility of the overall portfolio.

As the last few years have shown, while global equity markets tend to move in unison there can be large differences in performance especially over longer periods of time. If history is a guide, some of these differences in performance will revert as fundamentals re-assert themselves.

For example, the U.S. equity market currently trades at much higher valuation levels than international markets. Some of the valuation gap will most likely shrink over time boosting relative international market performance.

However the biggest lesson for investors is to evaluate international investments by evaluating both the attractiveness of assets in local currency (the fundamentals) and the likely rate of currency translation from local to base currency.

Too many investors ignore the role of currency in their international investments. Currencies hardly ever wash out, especially over holding periods relevant to most investors.

In order to effectively assess international investments you can't ignore thinking about currency and having a perspective on its likely effect.

If you believe that the U.S. dollar will appreciate relative to other currencies then your international investments will face a headwind.

If on the other hand you expect the U.S. dollar to be weak, your USD returns on international investments will benefit from currency gains.

When you invest in funds or ETFs denominated in U.S. dollars you have no choice but to think in terms of both local market returns and currency. Currency can be a significant source of returns to your strategy so best to have an informed view before you make any investments in international strategies.

About the author: Eric J. Weigel is the Managing Partner and Chief Investment Officer for Global Focus Capital LLC. The firm serves institutional investors as well as advisers outsourcing their investment management efforts. Weigel is also the founder of Retire With Possibilities.

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