Mutual Funds: Foreign Exchange Rates Can Crush Your Returns

The U.S. dollar is on a roll lately—gaining strength and trouncing currencies like the Euro and the Japanese yen. The dollar index, which compares the greenback’s value with basket of world currencies, is at a four-year high.

But is the strengthening dollar and weakening foreign currencies good news for you? For consumers, yes: A strong dollar means that you can buy imported goods more cheaply. For investors, it’s a bit more complicated.

When it comes to your foreign investments, weakening non-dollar currencies may be costing you dearly right now.

When an international mutual fund invests in Japanese stocks, let’s say, it buys those stocks with yen (even though you purchase and sell shares in dollars). Any changes in the share price are calculated in dollars, and that’s where a “haircut” can occur. Over the 12 months through the end of October, that haircut has been more like a buzz cut for many investors: The MSCI Japan index was up 18% in yen terms, but the same index priced in dollars was up just 1.3%.

Needless to say, the decline of foreign currencies is making it especially hard for international fund managers to beat their benchmark indices. Investing abroad has always involved currency risk, of course. But we’re now in a different world, and investors should take note.

Until recently, global currencies tended to move more or less in tandem, led by the dollar. But they’re no longer behaving that way. Part of the reason involves the stimulus measures that central banks have deployed in an effort to help their economies recover from the recession.

The United States recently wound down its “quantitative easing” stimulus strategy. However, the Bank of Japan has boosted its own stimulus effort, and the European Central Bank is expected to start a stimulus program soon.

These moves have helped to strengthen the dollar and send the euro and yen into a funk. Earlier this month, the dollar touched a seven-year high against the yen, and a two-year high against the euro.

While stimulus moves are partly behind the currency shakeout, we may be in for a sustained period of heightened uncertainty currency behavior. Two major factors:

• The United States is the clear global winner for growth, which is making the dollar attractive. The Japanese Central Bank is actively working to weaken the yen against the global currencies to improve the country’s trade balance.
• Europe is in the doldrums, with very low interest rates causing a flight to the dollar, where rates are expected to go higher.

There are ways investors can seek to protect themselves in this new period of currency fluctuation. Certain mutual funds and exchange-traded funds use hedging strategies to try to dampen the effect of currency swings, for example.

Other funds are designed specifically to bet on the rising dollar. However, currency trends are notoriously volatile and difficult to predict; they can work for or against an investor over time. That helps to explain why most international funds do not hedge their exposure to foreign currencies.

We continue to believe that there are great opportunities in overseas markets. But given the currency challenge, investors need expert guidance to carve out the proper international allocation within their portfolios. Don’t hesitate to contact us if you’d like to discuss international investing and currency risk.

Bijan Golkar is a Certified Financial Planner™ and licensed tax preparer with FPC Investment Advisory Inc. in the San Francisco Bay Area.