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Currency Effects on Investments

Michael Humphreys CFA® CAIA®

As a person living overseas, who may frequently travel internationally and be exposed to different countries and ways of living, foreign exchange and currency hedging may seem like a natural way to invest. However, currency fluctuations may have unanticipated consequences on your portfolio. So how should you approach currency as part of your investment strategy, if at all? Let’s take a look at the potential impacts of currency on your portfolio.

Currency Movements Are Hard to Predict

Currencies, like the US dollar or Singapore dollar, don’t follow clear patterns. Unlike stock prices or other financial assets, predicting currency value is tough because they tend to move randomly. Economists say they’re like a “random walk,” meaning their future direction can’t easily be guessed based on past behavior.

What Influences Currency Values?

Exchange rates between countries and their corresponding currency values are impacted by long-term drivers including:

  • Differences in inflation
  • Differences in interest rates
  • Current account imbalances (the difference in export prices: import prices ratios between countries) 
  • Public debt levels
  • Sovereign influence in currency markets

These factors tend to change slowly over time. However, in the short term, currencies can be under- or overvalued. When that happens and a correction does take place, markets tend to react violently, which can lead to unpredictable consequences.

Currency and Your Portfolio: Does It Really Matter?

Yes, currency movements can impact your investments, but it’s hard to predict whether the impact will be good or bad. 

Let’s look at June 2014–May 2017, as an example. During that time, the MSCI ACWI ex US stock index (large- and mid-cap representation in 22 Developed Market countries [excluding the US] and 24 Emerging Market countries) returned 1.26% per year on average. That same index, hedged back to US dollars, would have returned 6.54% per year. This example shows how currency can significantly affect returns.

While currency can create noteworthy positive returns as shown above, the opposite is also true. In fact, over longer periods, these significant differences tend to even out (a concept called mean reversion). So, you might gain from currency movements in one period but lose in another.

Protecting Your Portfolio from Currency Risk

There are two main ways to reduce currency risk:

  1. Buying only local equities and fixed income products (known as passive or natural hedging)
  2. Using active hedging tools like hedged funds, ETFs, or currency derivatives.

Reducing your currency risk by restricting your investments to local markets can lead to limited performance. For example, compare the S&P 500 to the SGX from October 2014 to September 2024. During that time, the US stock market grew by 197.36%, while the Singaporean-based market lagged far behind with just 10.98% growth. If you had only invested in Singaporean assets to avoid currency risk, you’d have missed out on significant returns.

S&P 500 vs SGX in SGD

While there were instances over that 10-year period when the SGD weakened significantly against the USD, you can see from the chart  that over time in mature markets, currencies tend to mean revert. 

USD.SGD Performance

The Costs of Hedging

While hedging can protect against currency swings, it’s not free. Hedging costs money, and in some cases, it may even increase your portfolio’s risk. For instance, if stock prices and currency movements are negatively correlated, hedging can lead to more volatility.

In developed markets like the US and Singapore, hedging costs are lower than in emerging markets. But they can still add up, ranging from a few basis points to over 40 points. You should also consider that when you hedge using forward contracts it can create taxable events, introduce risk that could hurt your portfolio’s performance, and create a higher expense ratio when compared to unhedged classes.

iShares S&P 500 Acc Hedged vs Unhedged


iShares S&P 500 Costs & Statistics

When Hedging Might Make Sense

In select cases, hedging may be helpful. For example, if you’re dealing with very volatile currencies or if you have a specific financial obligation in a particular currency, hedging can lower the overall risk of your portfolio.

But in general, for long-term investors, the impact of market performance tends to outweigh the impact of currency fluctuations. In fact, over time, the costs of hedging may reduce your returns more than any benefit you might get from protecting against currency risk.

The Bottom Line

When assessing an investment in FX, remember, it’s better to focus on investing in high-performing markets to produce the best results. Unless you are protecting yourself from short-term currency risk, stay aligned with your long-term financial goals and risk tolerance to create the financial future you envision for yourself and your loved ones. 


Sources:

CFA Institute. n.d. “Currency Exchange Rates: Understanding Equilibrium Value.” Accessed October 11, 2024. https://www.cfainstitute.org/en/membership/professional-development/refresher-readings/currency-exchange-rates-understanding-equilibrium-value.

CETF®, Tony Dong, MSc. 2022. “S&P 500 ETFs: Should Canadians Buy Hedged or Unhedged?” The Motley Fool Canada. March 5, 2022. https://www.fool.ca/2022/03/05/sp-500-etfs-should-canadians-buy-hedged-or-unhedged/.

Oey, Patricia. 2015. “Should You Invest in a Currency-Hedged International-Equity ETF?” Morningstar, Inc. April 8, 2015. https://www.morningstar.com/funds/should-you-invest-currency-hedged-international-equity-etf.

Sotiroff, Daniel. 2022. “Do Currency-Hedged ETFs Have Merit for the Long Term?” Morningstar, Inc. October 25, 2022. https://www.morningstar.com/funds/do-currency-hedged-etfs-have-merit-long-term.

This material is intended for educational and informational purposes only. It is not intended to provide specific advice or recommendations for any individual. Additionally, you should consult with your Financial Advisor, Tax Advisor, or Attorney on your specific situation. The views expressed in the material are that of the author and do not necessarily reflect those of any market, regulatory body, State or Federal Agency, or Association. All efforts have been made to report or share true and accurate information. However, the information may become materially outdated or otherwise rendered incorrect due to subsequent new research or other changes, without notice. The author nor the firm are able to always verify the content from third-party sources. For additional information about the firm, please visit the MAS Website at https://www.mas.gov.sg/  and the SEC Website at www.adviserinfo.sec.gov. For a copy of the firm's ADV Part 2 Brochure, please contact us at info@avriowealth.com.