Currency war has become a global buzzword phrase. It describes a situation where countries purposely devalue their currency to gain a competitive economic advantage. This tactic causes all kinds of chaos, including retaliatory action by other countries that can hurt international trade. It can also damage investment returns.
Let's examine how financial advisors can defend client portfolios against the disruptive forces of currency warfare.
Dissecting Returns
Foreign investments in stocks and bonds aren't just affected by local economic activity, interest rates or earnings—but by currency values too. While this doesn't diminish the importance of securities diversification, gyrations in foreign exchange rates are an added dimension of financial risk. How can financial advisors mitigate these risks in client portfolios?
The first step is to recognize that performance returns on international investments—whether they be stocks or bonds—are significantly impacted by the direction of the currencies those assets are denominated in. (Our case study of Japan below will illustrate this point.) This means that advisors should consider currency hedged positions when warranted.
Hedging tools like currency futures, forwards and options are available, but their complexity makes it difficult to implement a cost-effective hedging solution that clients can also understand. On the other hand, currency-hedged ETFs, because of their reasonable fees and relative simplicity, offer a viable hedging alternative.
Here's a quick snapshot of the top currency hedged equity ETF providers:
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Deutsche Bank offers 11 X-trackers MSCI international currency hedged equity ETFs that charge annual expense ratios between 0.35% up to 0.65%.
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BlackRock's iShares offers 5 currency hedged ETFs that charge expenses 0.39% up to 0.70%.
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WisdomTree offers 12 currency hedged ETFs that charge annual expenses between 0.43% up to 0.58%. The company also offers a Japan small cap fund (DXJS) along with Japanese sector funds like financials (DXJF) and real estate (DXJR).
Currency Catalysts
A major driver behind the ups and downs of currency prices is the monetary activity by global central banks. Advisors should ask: What is the monetary cycle of the international market where I'm investing clients' money and how will it affect returns?
"There is no bigger global macro play right now than long U.S. dollar versus other currencies in particular the euro," said Frank Stanley, a CFP and president of Global Wealth Analytics in Encinitas, California. "The U.S. is at a stimulus unwinding point and the ECB and other countries are midway through their stimulus measures. These moves can last six months to two years so they are shorter term in nature."
If a central bank is in a loosening cycle, a weaker currency in that respective country or region is likely. On the other hand, a tightening phase is more likely to lead to a stronger currency and less need for hedging. "Ignoring these factors would have a major impact on foreign equity positions," notes Stanley.
Case Study: Japan
The historical performance of currency markets shows there's a very close correlation between central bank activity and the value of currencies.
