If you’re an investor, the logic is similar. If you hold non-U.S. assets, the returns on your investments will be affected when you translate your investment from its local currency back into dollars. So, while most well-diversified portfolios should include investments in countries outside the U.S., you should also consider whether you need to attempt to cushion their currency impact.
Market Realist – You should hedge your currency exposure in order to maximize returns.
If you are an US citizen investing in Germany (EWG) or Europe (FEZ), your total return—when you convert it back into US dollars—depends on the stock or index returns and the change in the euro-US dollar. It’s roughly the addition of the two.
The graph above compares the returns on the MSCI EMU Index (EZU). This index measures the performance of stocks based in the European EMU (Economic and Monetary Union) along with the approximate total returns after taking currency loss into account.
The MSCI EMU Index gave returns of 21.7% in the last 12 months. However, the euro—the currency used in the EU (European Union)—depreciated by 24.7% in the same period. As a result, despite decent returns over the last 12 months, the total return is -2.5% due to the stronger US dollar (UUP).
If your investment is in an economy that’s experiencing currency losses, your losses on the stock market can be magnified. So, it’s important to hedge your currency exposure.
Currency hedging is particularly important if you want to invest in Japanese stocks (EWJ)(DXJ). The Nikkei 225 is an index that’s heavy on exports. When the Japanese yen depreciates, the Nikkei 225 will gain because a weaker currency makes that country’s exports attractive. With the yen depreciating, the Japanese index could gain more. However, if it isn’t hedged, you likely won’t get anything from that investment.
The US dollar will likely strengthen more in the short term. If you’re in the US, you should consider hedging your international investments (ACWI).