Where to seek shelter in a global currency storm?
Imagine sailing on the ocean on a peaceful day when suddenly, almost instantly, everything changes. A cold front rapidly moves in, and the idyllic scene turns chaotic.
That was the currency market in January 2015. The wild gyrations in the Swiss franc took center stage when the Swiss National Bank abruptly stopped buying euros, sending the euro/Swiss franc exchange rate down more than 30% before recovering. Other foreign currencies dropped too, continuing the trend of weak foreign currencies and a strong U.S. dollar that I wrote about last week. While currency rates were volatile in the latter half of 2014, that period was more like a mild squall compared to the Category 5 hurricane in January.
For U.S. investors with overseas holdings, weak foreign currencies are likely to be a significant concern. That’s because there are two ways to earn profits from international investments. The first is the value of the investment. For example, if you own a German stock, you hope the price - in euro terms – will rise. The second is the exchange rate. One can potentially benefit from an increase in the euro/U.S. dollar exchange rate. Thus, a drop in the value of the euro can cut into a U.S. investor’s overseas earnings. Some investors welcome the currency gyrations, believing they are likely to profit from the volatility. Others are uncomfortable with foreign exchange risk and would prefer to avoid it.
Managing currency risk is not overly difficult or costly to do, either for institutional or individual investors. Both types of investors can use hedging techniques to help manage currency risk. Hedging involves selling foreign currencies and buying the domestic currency, say the U.S. dollar. By selling a foreign currency, you lock in its price. For example, if you own German stock valued at 100 euros, you could sell up to 100 euros and buy U.S. dollars. Then you would own 100 euros worth of stock, but since you sold an equal amount of euros and received dollars in exchange, now the movements of the common currency are very unlikely to affect your investment. Of course, there are potential risks for loss with this approach, like any other investment.
Institutional investors often hire a specialist to help them with their hedging needs. What about smaller investors whose portfolios aren’t large enough to be part of an institutional portfolio? Individuals can ask their advisor for currency hedging solutions as part of a multi-asset investment approach. Such active hedging can be accomplished with mutual funds, separate account products or exchange-traded funds (ETFs). In such a strategy, the investor buys a currency hedging product that invests in overseas equities but hedges the currency risk, helping to obtain a similar outcome that institutional investors might get by working with a specialist.
The turbulent currency market might not clear up in the near-term, because the world’s central banks are pursuing different policies to help their economies. Such objectives can influence exchange rates, much like the Swiss National Bank did with the euro in January of this year. These circumstances probably mean more rough seas ahead for investors with international investments. It might be wise to batten down the hatches with a good currency hedging program.
Visit us to learn more about currency management options that Russell Investments offers to institutional investors.