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Forex Risk With Foreign Investments

There's a lot of talk in the financial world about how foreign stocks are "less expensive" relative to American stocks, and why it's a good idea to "diversify" into those assets just based of that metric. First of all, "di-worse-sification" is a very real concept that we hold dear to our process. Buying a stock or ETF in a particular sector or country simply for the sake of diversification seldom rewards the risk incurred from doing so. You need to know what you own, why you own it, and how much you're willing to risk on it-- always. There is no exception.

Anyhow, the risk we want to focus on today is with respect to currency fluctuations, or forex (foreign exchange). Ever since debt-based, floating exchange rates came into effect in 1971, when President Nixon halted the option to redeem dollars for gold, forex risk became much more prevalent in international investing. Granted, currency values have always fluctuated throughout history, but not near the way they have in the last 50 years.

Much of the risk associated with foreign investments now is masked through ETFs. In most cases, there are foreign funds that provide both options, to hedge or not to hedge, for forex risk. The key to knowing which type to buy, if ever, lies in the analysis of currency markets.

Here's an example (assuming you live in the United States):

You decide to invest money in Europe without hedging for currency risk. Say you use an indexed ETF to achieve this. So you buy the fund, which itself will convert the dollars into euros, and then buy shares of European corporations. After a few months, the fund is up 7%, but when you look at European stock indices by themselves, you notice they're up 10%. Frustrated, you look at the ETF's expense ratio, and realize it's not even 1%. What happened to the other +2% of supposed return?

Forex risk.

During that same time period of a few months, the U.S. Dollar appreciated versus the Euro by 2%. Because the fund you bought didn't hedge for local currency depreciation, you lost 2% on your real return. When it comes to investing globally, real returns are significantly more important than nominal returns.

Of course, the inverse can be true, and the example above was just that, an example. The Euro could have appreciated by 5% during those same months, and actually added to your return. But let's keep it simple for this article's sake.

So here we have a chart of the U.S. Dollar, and it looks bullish. We wished the bears on this currency the best of luck in this week's Weekly Memorandum, as we continue to see a global demand for dollars and dollar-denominated assets. Investors outside of the U.S. are clearly willing to pay a premium to participate in just a slice of the American economy.

This is something we have emphasized for months in the Mercator Letter, and something we will continue to do, as long as the dollar continues to behave in accordance with our expectations.

In summary, buying a fund in a particular sector or economy just because it's "cheap" usually doesn't work out well. Yes, some of this is experience speaking. Capital flows are much more important than fundamentals.

Markets trend, and few, if any individual investors have the buying power to actually move a market. Let the institutions do the heavy lifting for you, and as always, avoid "di-worse-sifying" just because a financial article said it's a good idea.

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