How Foreign Currency Fluctuations Can Affect Your Return

Christine Benz: Hi, I'm Christine Benz for Morningstar.com. Currency fluctuations can be a wild card for investors in foreign stocks. Joining me to discuss that topic is Patricia Oey. She is a senior analyst in Morningstar's Manager Research Group.

Patty, thank you so much for being here.

Patricia Oey: Thanks Christine.

Benz: We're doing this Risk Management Bootcamp on Morningstar.com this week. We wanted to talk specifically about this currency issue because it does tend to be somewhat unpredictable and it can have an impact on foreign stock investors' returns. So, let's start there and talk about the ways in which foreign currency fluctuations can affect your return.

One is simply when you take your foreign currency gains and you translate them back into U.S. dollars assuming that you're an investor in the U.S. You have an impact there. Let's talk about that.

Oey: So, in 2015, we saw the dollar generally rise against other currencies which means that the other currencies are falling. So, just as a very simple example, if you are invested in an index fund that's invested in Eurozone securities, like continental Europe, the markets over there were up about 10%. But if you are sitting here in the U.S. and you were not hedged, because the dollar was rising and the euro was declining against the dollar, your returns would have been about negative 1% gain versus the 10% gain in local currencies. So, the translation effects, that's an example of a translation effect.

Benz: And sometimes I know anecdotally investors sometimes think, well, my foreign fund didn't perform that well, so foreign stocks must be cheap; not necessarily. Sometimes those translation effects can be the thing that were depressing your fund?

Oey: Right. Correct.

Benz: So, let's talk about how currency effects can impact businesses because there can be an effect there as well.

Oey: So, maybe like a common example is, maybe the Japanese automakers. So, again, the dollar was rising and the yen was falling over the last few years. But in 2016, we're seeing that reverse where the dollar is weakening and the yen is getting stronger and this morning, we heard Toyota say that the strengthening yen is actually impacting their business. They are expecting revenue and profits to decline. I mean, generally speaking, over the last few decades they have tried to build more manufacturing facilities in their main markets. But the reality is that they are still mostly net exporters. Most of their manufacturing is in Japan.

So, here in the U.S., if the yen is rising, the Japanese cars seem more expensive to us, or maybe we're less likely to buy Japanese cars and that's why it's negatively impacting their business. So, while the Toyota stock in Japan, it might be declining because of these like fundamental headwinds, these currency headwinds, if we're sitting here in the U.S. and we invest in the Japanese stock, maybe the stock itself is declining but because the yen is rising that may boost the returns. So, there's two different forces going on. It's a very complicated issue.

Benz: Yeah, definitely. So, fund managers and certainly, individual investors to some extent, can hedge out that currency risk and I want to talk in a second about what that is and how that works. But first, let's talk about the simple fact that if you're looking at some sort of foreign stock fund, most of them will not be hedged in any way, meaning that they will be fully exposed to these foreign currency effects.

Oey: Right. So, if you talk to a lot of foreign equity managers, they will say that they are not currency hedged. They say their specialty is in picking stocks. They don't pick when currencies are going to go up and down and they prefer to remain unhedged. But the reality is, also is that currencies, while they may become dislocated from their fair value over the short term, over the long term they tend to trend towards what their true value really is. And if you look at long-term returns, a hedged index versus an unhedged index over a decade, two decades, three decades, the returns tend to almost the same. So, for a long-term investor, currency fluctuations do add noise. But if you are sitting tight and you are in it for the long term, you can withstand inevitable volatility and net-net, the returns are probably almost the same.

Benz: So, there's probably going to be a little bit of volatility associated with those currency-related moves. Do I pick up any diversification by having an unhedged foreign stock fund in my portfolio?

Oey: So, some people say that actually having that long exposure to currencies can add diversification. It's definitely a little bit hard to say. It's still hard to say conclusively. When people own an international equity fund, it tends to be geographically diversified. So, you'll have yen exposure, euro, Canadian dollar, Australian dollar. And to get a little more technical, some currencies are pro-cyclical, like maybe Canada and Australia, they tend to be commodity-oriented, so their currencies are kind of pro-cyclical and something like the U.S. dollar or say the yen, those currencies tend to go up when markets are in risk-off because they are considered safe-haven currencies.

Benz: So, when people are worried, they like U.S. dollars…

Oey: Or yen, and those currencies tend to go up, whereas maybe like Canada and Australia, those currencies will go down when risk is on. So, you hold the portfolio of all these different currencies and they are all kind of working in different ways. So, it's hard to say conclusively whether it adds or doesn't add diversification.

Benz: So, the flipside of that, we talked a little bit about how some funds, increasingly some of these ETFs, are set up to sort of wash out the currency fluctuations, they're hedged products. Let's talk about sort of--we don't have to get to into the mechanics, but what's the basic idea there?

Oey: Maybe over the last five years until 2016 the U.S. dollar has been gradually rising against these other currencies and when that's the case, a hedged product will outperform an unhedged product because the foreign currency is declining against the U.S. dollar. So, bunch of these--like dozens of these products--launched over the last five years and they have lots and lots of assets and they are very popular and they are useful for making tactical bets. Generally speaking, we don't advocate betting on which way currencies go. But, I mean, they are liquid products. They tend to be fairly inexpensive. If that's your thing betting on currencies, you're perfectly fine to use.

Benz: So, if I buy one of these hedged products, the basic idea is, I'm going to experience the gains or losses in these foreign securities, but I don't want any of the foreign currency-related fluctuations?

Oey: It removes all the foreign currency fluctuations. They do that by using currency futures or forwards. In terms of cost, hedging cost tend to not be very much. Very simply, if you want to think about it, the cost is usually the interest, the short-term interest rate differential between two currencies and the U.S. dollar versus the yen, versus the euro--I mean, we are all at practically zero rates.

Benz: Pretty close proximity to one other.

Oey: Right. So, the costs aren't very high. But it's more to note that in the emerging markets that's not the case at all. So, some currencies are actually very, very expensive to hedge and some of them there are actually no derivative products to use to hedge certain currencies. So, it's fine to hedge a developed market currency, but for emerging markets, you don't want to hedge because A, it may not be possible or B, it's very, very expensive.

Benz: Let's talk about how investors should approach this decision about whether to hedge, whether to be unhedged. You mentioned that you are not a fan of the idea of sort of tactical maneuvers that, oh, I think the yen will go down, so I'm going to do Y; I think the euro will go up, so I'm going to do X. You think that investors should just kind of play the long game here.

Oey: Right. So, definitely again because the returns over the long term tend to be the same whether you're hedged or not hedged, we don't necessarily advocate hedging. That said, the ETFs, they tend to track market cap-weighted indexes; they tend to be reasonably diversified and they tend to be quite cheap. So, if it's a view that you have that hedged product will be a little bit less volatile than an unhedged product, if that's something that you feel more comfortable with, you can add a little bit of these hedged ETFs to your portfolio and that's a reasonable long-term decision.

Benz: Most of the active funds though will be unhedged, correct?

Oey: Correct. It's only about a handful of funds that are …

Benz: Tweedy, Browne Global Value I know is one, but it's in the minority.

Oey: Correct. Right.

Benz: Patty, thank you. It's a complicated subject. Thank you so much for being here to share your insights.

Oey: Thank you.

Benz: Thanks for watching. I'm Christine Benz for Morningstar.com.