With U.S. equities coming off a multi-year rally, more investors are starting to look to overseas markets as a way to diversify their investment portfolio. However, some are beginning to see specific risks in foreign equities exposure, notably foreign exchange currency risks.
In a recent research note, Dodd Kittsley, director and head of ETF strategy at Deutsche Asset & Wealth Management, tries to dispel a number of common misconceptions about the role of currency risk in a portfolio.
For starters, Kittsley points out that while exchange rates return to equilibrium value over time – currencies don’t indefinitely appreciate or depreciate but rather go through cycles, exchange rates can still swing over short periods.
“Exchange rates can and do diverge from the equilibrium rate implied by purchasing power parity or other valuation models, and these divergences can last for years and be very significant in magnitude,” Kittsley said. “Investors must consider if they are able to weather such significant short- and medium-term swings in investment performance.”
For instance, currencies returned as much as 15.2% in 2003 to as little as -12.0% in 2005. Consequently, investors should consider whether or not currency hedging strategies is right for their portfolios.
Additionally, the DeAWM strategist also argues that investors should consider currency expsoure as an additional source of return as well as an additional source of risk. For instance, he believes that investors in or nearing retirement should consider currency hedging international equity exposure to diminish cash flow variability.
“The risk (volatility) of a currency unhedged investment has three primary components: the volatility of the equities, the volatility of the currencies, and the correlation of the two,” Kittsley added. “Currency volatility is typically less than that of equities, making the correlation figure an important contributor to overall volatility.”