How Currencies Affect Global Markets … and Your Portfolio

As a modern investor, you need to be aware of many global factors that have the potential to influence your portfolio’s performance. In order to stay diversified, you’ll need some exposure to non-U.S. assets, and that means you should understand how currencies affect global markets.

Here’s a brief guide to where you should focus your attention.

How Currencies Affect Global Markets

We normally define “total return” as the combined effect of asset price appreciation and dividends paid. What does that mean? If your shares of Coca-Cola rise by 8 percent and offer an annual dividend payment of 2 percent, then you’re making a total return of 10 percent.

When you invest in non-U.S. assets, however, there is a further wrinkle to this definition: the price appreciation (or decline) is in turn a combination of the asset price movement and the exchange rate between your home currency and U.S. dollars. Here’s an example to show what we mean.

You invest in the common stock of a Malaysian industrial concern. The local currency in Malaysia is the ringgit. Over a one-year holding period your investment appreciates 5% as measured in ringgits. But over the same time period the ringgit falls by 3% against the U.S. dollar – in other words it takes more ringgits to buy a dollar than it used to.

Here’s the thing: since you live in the U.S., your portfolio’s home currency is the U.S. dollar. So when you translate a foreign currency gain into your dollar-denominated performance report, that gain will decline if the local currency has fallen against the dollar. Specifically, your 5% ringgit price gain will be offset by a 3% currency loss for a net gain of 2%.

Should You Hedge Currencies?

Currencies can fluctuate wildly in a multi-trillion dollar trading market. Because of this volatility, many investors hedge their foreign asset exposure. Currency hedging involves offsetting the currency effect of the total return, as described above, by taking a short position in the foreign currency. A fully hedged position in the above-mentioned Malaysian asset would offset the 3% currency loss, so that the investor’s U.S. dollar-denominated gain would be 5%.

Of course, that result could go either way. When the U.S. dollar declines, the value of foreign-denominated assets will increase commensurately. If you fully hedged your exposure to the ringgit and the ringgit were to appreciate against the dollar, you would not enjoy the benefits of that appreciation when measuring your dollar-denominated performance.

Furthermore, hedging costs money. If you invest in a mutual fund or ETF that routinely hedges its foreign currency exposure, you’ll pay a cost built into the fund’s structure that would not exist for an unhedged fund. As an investor you need to consider whether the cost will be worth it over the long term.

If you have a long investment horizon, you probably do not have a solid basis for predicting whether the dollar will be stronger or weaker over that horizon. It may be a smarter move to simply accept currency exposure as a fixture of a diversified portfolio.

How do you handle non-U.S. currency exposure? Tell us what you think.