BOSTON (MarketWatch) The world is hyperventilating over inflation and municipal bonds right now. And with good reason. But there's another issue that has analysts in the investment world putting finger to keyboard. And that would be currency risk.
As many are well aware, these have been rocky times for the U.S. dollar. In fact, the exchange-rate volatility of the U.S. dollar hit a multi-decade high in 2010, with three-year volatility near its highest level in more than three decades, according to Dirk Hofschire, vice president of market analysis for Fidelity Investments.
And that volatility has proven especially over short time periods to be a cause for concern for those who have increased their exposure to international stocks, bonds, ETFs, and mutual funds. "A strengthening dollar lowers foreign stock returns to U.S. investors because the return achieved in local foreign currency is worth less when converted into relatively more expensive dollars," Hofschire wrote in an article about the potential benefits of foreign currency exposure. "Conversely, a weaker dollar typically leads to higher returns for U.S. investors: When the U.S. dollar declines vs. foreign currencies, foreign stocks that appreciate in local currency are worth more when converted back into cheaper U.S. dollars."
But concerns over that volatility and the effect on one's investments might be unnecessary. That's because, according to Hofschire's research, currency movements historically have had low correlations with the local-currency-denominated price movements of foreign stocks. "In other words, the price changes of foreign stocks have had little to no relationship with the change in the exchange-rate value of the U.S. dollar."
(Correlation is a measure of how different assets move in relationship to one another, and are measured on scale from 1.0 (directly correlated); 0 (no correlation); and -1 (inverse correlation), wrote Hofschire.)
In his paper, Hofschire showed that U.S. stocks have had a modestly negative correlation (-0.19) vs. foreign-exchange movements during the past 25 years. And as a result, "currency movements can help lower correlations between U.S. stocks and foreign stocks," he wrote. "For the 25-year period ending in December 2010, foreign stock returns in local currency terms had a correlation of 0.75 to U.S. stocks. However, incorporating the impact of currency movements by looking at the returns of foreign stocks in U.S. dollar terms resulted in a lower correlation of 0.69 over the same period."
And combining assets with low correlations against one another can help boost the risk-adjusted returns of an overall portfolio, Hofschire wrote.
(Typically, you'd want to build a portfolio with assets that have little or no correlation or that are negatively correlated. That way, when one asset declines in value, another should rise.)
According to Hofschire, it's hard if not impossible to predict the ebb and flow of currency movements over time. In the short-term, Hofschire said, such movement might either help or hurt your portfolio's performance. "And you don't want to get into the conundrum of trying to time the market," he said in an interview.
What we do know, however, is this: "The historically low correlations between currency movements and stock prices suggests that currency exposure is one way long-term investors can help achieve portfolio diversification benefits, such as lower portfolio volatility and improved risk-adjusted returns."
And that largely means adding international funds and international ETFs to your portfolio if you haven't already.
Ian Toner, a chartered financial analyst and head of currency implementation at Russell Investments, agrees that investors need to be exposed to international assets. But he also thinks that investors will need to become increasingly conscious of their currency exposure.
"There does seem to be some benefit in diversification terms and some would say return terms from being exposed to currency," said Toner, author of the just-published white paper titled A New Approach to Understanding Currency Exposure. "And the traditional approach to getting exposure to foreign currency was to buy foreign investments denominated in local currency. And it usually stopped there, he said."
But Toner is of the opinion that investors will have to go one step further in future in the chase for even higher risk-adjusted performance. "Because both the amount of currency exposure and the nature of that exposure matter, I need to consider not only adjusting the amount of exposure (through hedging), but also changing the nature of that exposure (through some form of currency management," he wrote in his paper.
Unfortunately, he said the products that would enable ordinary investors to hedge their currency exposure are not easily available just yet. But those who want to be on the bleeding edge of boosting their returns should be on the lookout for the tools that would enable them to assess their currency risk and make adjustments. The day when ordinary folks can manage their money in the same way as institutions is fast approaching.