International Investing: How Currencies Can Make or Break a Portfolio | ETF Trends

International investing is often about perspective.

From the viewpoint of some international investors, the past five years have been rather rough. Take for example those focused on the MSCI EAFE USD Index, a broad benchmark of developed market equities from around the globe. Following this index would have resulted in a gain over 1% in just one of those five years, and three years of negative returns.

From this perspective, it has been a pretty poor time to be in international markets, but that certainly hasn’t been the experience for all. In fact, other investors—utilizing the exact same securities that are in the MSCI EAFE USD Index benchmark— saw four out of five positive years, including four years with returns of at least 5.3%.

How is this possible? It is all thanks to the astounding impact that currencies can have on a portfolio.

By instead following the MSCI EAFE Local Currency Index, a benchmark which includes the same securities of the MSCI EAFE USD Index but merely excludes the impact of currencies, investors would have dodged a significant amount of local currency weakness over the past five years. The benefit to this strategic shift is evident in the chart below:

In four of the past five years, hedging currencies produced better returns. Moreover, in two of those years, returns flipped from negative to positive, solely thanks to removing the impact of a strengthening dollar (or weakening foreign currencies, if you prefer). Such a marked improvement came without changing any securities, just the kind of fresh perspective that could have been enough for some investors to have a different experience in international investing.

Volatility too

While it is true that an unhedged strategy would have outperformed in 2017, it is important to note how unstable an unhedged strategy was over the past few years in particular. The inclusion of currencies added an additional layer of volatility to the picture, potentially increasing the risk factor for investors in the process.

The standard deviation for the local return index was below 9.5% while the unhedged benchmark was over 14.4%.[1] In other words, not only was the hedged currency version less volatile, but it delivered better returns, all the while holding the same exact securities.

Bottom line

Currencies matter, and at least in recent history, they have had a negative impact on portfolios. Given that and their long-standing reputation for adding volatility, it would seem increasingly hard to make the case for including foreign currencies in a portfolio. This may be particularly true in today’s market environment, since it features broad dollar strength, a characteristic which can further depress unhedged returns.

So, if you’ve been avoiding international investing lately, it may be time to change your perspective. Your viewpoint could just be the result of excluding the often volatile effects of foreign currency or not.

[1] Data is for the time period 2014-2018. Calculation made with Morningstar data from December 31st, 2018.