The Currency Effect in Foreign Investing

This article was written for and also appears at ETF Market Pro.

Currencies are different than any other type of investment. The recent sharp fall in the dollar means good things for US investors who are investing abroad. Looking at where foreign investment returns really come from can give a perspective on the purpose of holding foreign assets.

Currencies, unlike stocks, bonds and commodities, can only derive value on a relative basis against other currencies.  For example, the US Dollar can increase in value against the Euro while decreasing in value against the Chinese Yen.  So, currency valuation is always on a relative basis, as it’s a matter of perspective.

Recently, it has been popularized that investors should invest portions of their portfolios overseas in developed markets like Europe and developing markets like Brazil, Russia, India and China-coined the BRIC countries.

Every investor who invests money in international markets should know what really drives returns. The naïve thought would be that those assets alone cause price fluctuations. However, taking an in-depth look at international returns, we can see that US investors can receive much more benefit and punishment from currency fluctuations than meets the eye. 

The chart below shows the price appreciation in the MSCI EAFE Index. MSCI EAFE is the index representing equity in developed nations within Europe, Australia, Asia and the Far East (EAFE). The Red line depicts the index measured in US Dollars while the blue line measures the EAFE Index in its local currency with no currency effect. The time period is 1969 through July 2009. The difference is noteworthy.

The MSCI EAFE Index is tracked by an iShares ETF, the iShares MSCI EAFE Index Fund (NYSE Arca: EFA).

1

Source: MSCI Barra

The currency effect in the EAFE Index is the difference between the two lines. Since 1969, currency has benefited the US investor. Looking at the difference on an annual basis over that time period shows that currency adds volatility.  Below is the excess return the US investor had caused by currency. The calculation is simply the difference between the returns of the US Dollar Index and Local Currency Index.

2

Source: MSCI Barra and author’s own calculation

Since 1969, currency has increased returns to the US investor.  However, volatility was also increased by 16%, meaning that monthly returns varied up or down from a long term average 16%, more than they would have without currency effects.

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