International travellers know that when they go abroad, they will have to exchange pound sterling for other currencies before they can hop in a taxi or pay cash at a restaurant. The same holds true for buying stocks on a foreign exchange, or doing so indirectly via a foreign mutual or exchange-traded fund. Before U.K. investors can buy shares of a foreign stock, they must first trade in their pounds for the foreign currency in which the security is denominated. And when they sell the stock, they'll receive the proceeds in the foreign currency, which they must then exchange for pounds. Appreciation or depreciation in that foreign currency over the time they've held the stock might affect returns--sometimes for the better, sometimes for the worse.
How Do Currency Fluctuations Work?
The value of one currency relative to another can fluctuate for a variety of reasons--the interplay between the countries' trade balances, fiscal and monetary policies, rates of economic growth, and inflation, to name some of the key ones. Foreign currency exposure can be beneficial as part of a well-diversified portfolio because it adds another layer of diversification, much like being diversified across stocks of different sizes and styles.
At the same time, exposure to foreign currencies can also affect a portfolio's performance, sometimes on the upside and sometimes on the downside, particularly during shorter periods of time.
For example, say you are a U.K. investor, and you buy the Japanese stock Sony directly on the Tokyo exchange. The return that you will realise is affected by both the change in the price of the stock as well as the change in the value of the Japanese yen against the British pound during the time that you own it. If the stock price of Sony rises by 10% but the yen falls 10% against the pound during the time that you owned it, you'll have no gain at all. But if the stock price of Sony rises 10% and the yen appreciates 10% against the pound, you'd pocket 20%--the 10% rise in the stock price as well as the 10% rise in the currency. Note that the aforementioned example relates to securities purchased directly on a foreign exchange.
Managing Currency Risk
Although it's true that foreign-currency fluctuations frequently capture headlines and there are more and more vehicles set up to capitalise on various foreign currencies, actively managing your portfolio's currency exposure is a tricky business. Foreign-currency fluctuations are driven by diverse, difficult-to-predict factors such as economic growth, deficits, and interest rates, not just here in the United Kingdom, but in other countries, as well. Just when all of these point to a currency heading in one direction or another, they can quickly flip the other way. So rather than trying to predict the timing of currency movements, one way to reduce the impact of short-term price changes is to invest for the long haul and tune out short-term noise.
Investors in actively managed foreign-equity funds should also be aware that their managers might be adjusting their currency exposure via a process called hedging; For example, let's say that a manager buys Sony but hedges the portfolio's currency exposure by selling Japanese yen and buying pound sterling. In such a situation, if Sony's stock rises 10% and the yen falls 10% against the pound, the fund pockets the 10% gain and the currency fluctuation has no effect.
Some mutual funds also hedge their currency exposure by making investments across multiple currencies in an effort to offset currency risk. For example, a global fund might hold securities from the U.S., Europe, and Asia. Typically, a rise in one currency is offset by a decline in another and is commonly referred to as a natural hedge.
Investors should read the fund's prospectus to understand management's currency-hedging policies. Being aware of the potential effects of currency fluctuations and the fund's approach to cushioning against its risks won't necessarily ensure a smoother ride, but it will help better prepare investors when a fund either suffers or benefits from currency movements.
It's also worth noting that maintaining no exposure to foreign currencies presents a risk of its own, as Morningstar fund analyst Gregg Wolper highlights in this article. If the euro spikes, for example, having portfolio exposure to euro-denominated securities helps offset the higher prices consumers would pay to buy goods from or travel in the eurozone.
