When putting money into an international fund, investors need to be familiar with certain risks that they don’t typically encounter with U.S.-based funds.
In overseas investing, currency movements play a major role in a fund’s total returns. Understanding how foreign currencies behave against the U.S. dollar can help investors manage foreign exchange risk in their portfolios.
In case you are wondering whether mutual funds are right for you at all, you should read why mutual funds, in general, should be a part of your portfolio.
The Concept of Currency Risk
With securities denominated in a non-U.S. dollar currency, exchange rate movements could either enhance or diminish the return of that security. Currency risk, or exchange rate risk, comes from the chance that exchange rate movements could negatively impact an investment’s total return.
It is important to note that currency risk can affect both the price appreciation of a security and the dividend and interest payments it makes.
How to Hedge Against Currency Risk
Many international funds are exposed to currency movements, but some choose to eliminate that risk through hedging. Funds will do this through the use of currency forward contracts. These contracts allow the fund to lock in a future exchange rate and protect shareholders from potentially adverse movements in currency exchange rates.
Consider the PIMCO Foreign Bond Fund (Unhedged) (PFUAX) and the PIMCO Foreign Bond Fund (USD-Hedged) (PFOAX). The two funds are substantially similar, except that one is currency-hedged and the other is unhedged. The U.S. Dollar Index has fallen this year, meaning funds that are denominated in the dollar would see diminished returns due to the decline in the exchange rate. That’s what we’ve seen with these two funds in 2017, with the unhedged fund up almost 9% year-to-date, but the U.S. dollar-hedged fund up only 2%.
Be sure to check our list of currency mutual funds here.
Why Exchange Rates Might Move
Exchange rate movements are a reflection of short-term economic conditions and can occur because of a number of different factors:
- Interest rates – Higher interest rates lead to higher rates of return for investors. An increase in demand from abroad for these higher rates can translate into higher value in the domestic currency, and vice versa.
- Trade balance – The balance of trade between imports and exports can impact the supply and demand for currencies. If a country’s exports exceed its imports (or the overall pricing of exports rises faster than the pricing of imports), it can result in greater value for its currency as well.
- Public debt – High levels of government debt can have a negative impact on a country’s exchange rate. A mountain of debt can create the perception that the country is in poor financial shape and has the potential of defaulting if it accumulates debt that it can’t pay off.
- Political environment – A country experiencing political unrest or governmental instability likely makes for a less attractive investment opportunity. The markets hate uncertainty, and concerns about the political environment generally lead to lower value in the domestic currency.
The Pros and Cons of Currency Hedging
Hedging against currency risk can have both positive and negative effects. On the plus side, currency fluctuations give investors the opportunity to improve the overall returns on investment. Investors who are able to identify some of the factors that cause a currency to rise or decline can profit from such opportunities while helping to limit some of the downside risk.
On the other hand, currency risk hedging does not eliminate some of the risks of exchange rate movements. If you hedge away currency risk, there’s still the risk that you could miss out on gains if the currency appreciates in value. It’s difficult to predict movement in exchange rates, so the risk of missing out could be costly.
Key Considerations for Investors
International funds have performed particularly well over the past year, and have attracted a lot of investor money. Much of that money is showing up in retirement accounts, so understanding the impact of exchange rate movements is especially important in that segment of the marketplace. Given the long-term time horizon and the difference in performance, choosing the right product could add thousands of dollars to your account.
Another important consideration to note is that hedged funds typically cost more to operate than unhedged funds. The additional step of layering on forward contracts and managing currency positions tends to drive up expense ratios.
The Bottom Line
The hedged versus unhedged debate isn’t a simple one as it has a lot of moving parts. There’s no doubt that being able to gauge the direction of exchange rates can significantly enhance the returns for many foreign investments. But it’s a challenging task, with few being able to accurately forecast the direction of rates.
Be sure to check our News section to keep track of recent fund performances.