It is important to have some international investments if your goal is to have a diversified portfolio. However, it is easier said than done, especially when countries around the world are adopting diverging monetary policies. For example, currently Japan and some of the European countries are committed to extremely low or even negative interest rates, while the Federal Reserve in the US has raised the interest rates after a very long time. Under such circumstances, you can expect the currencies to experience a bumpy ride for at least some time to come.
If you look up the DXY index, which measures the value of the USD with respect to a basket of important world currencies, to have an idea of the volatility last year, you will see that it has increased from 6 percent to 12 percent. This makes any prediction on the direction of movement, up or down, increasingly difficult.
However, the US dollar has remained stronger this year amid volatility in the global markets. This does not mean that there are no potential opportunities abroad, but it is suggested that American investors must think about mitigating currency risk when making overseas investments. This is because the returns on your international investments are dependent on hedging the currency risk. When you make invests in an overseas market, you are also investing in the currency of that currency.
As such, here are the three aspects you have to keep in mind when you think in terms of international invests:
#1: The Currency Investing Equation
This equation will demonstrate to you the fact that the changes in currency exchange rates can potentially enhance your returns or diminish the earnings from your portfolio. At times, if the situation is very bad, you could end up making huge losses.
This is why it is very important to consider and build a currency hedging strategy. Hedging against currency risk basically helps you to take the effect caused by exchange rate variations out of the currency investing equation. However, it has to done at the right time in order to really ensure a difference in your portfolio’s performance.
That said, the fact is that it is not easy for anyone to time the currency price movements. Further, it has always been observed that decision making by investors lags developments in the markets. This is to say that many investors make their buy and sell decisions at the most inappropriate times. This phenomenon has been observed not only among currency traders, but also among other participants in the financial markets. It is the volatility that is inherent in the forex market which makes taking the right decision at the right time very, very critical. You can easily understand the impact of the disconnect between the strength of the U.S. dollar and the Japanese yen if you take a look into the flows into funds that have hedged against currency risk since April 2014.
#2: Market Timing and Flows into Currency-hedged funds
If you are confident of your ability in predicting the price movements of currencies even in volatile conditions, then it is a good idea to make use of fully hedged traditional exchange traded funds or ETFs as a tool to target for specific opportunities in the short term. It also helps to take currencies entirely out of the investing equation.
On the other hand, if you are not sure of your ability to predict price direction of assets in volatile conditions, then you may consider the iShares adaptive currency hedged ETFs. They offer a reasonably good solution when it comes to allocations into developed markets in the world. The investments into such funds helps investors to avoid the task of figuring out as to when they should and how much they should hedge when making investments in foreign markets. This is because these funds are designed in such a way that they will adjust to the currency environment which keeps changing. This is to say that such funds help to eliminate the guesswork involved out of the equation. You also don’t have to manage a currency risk hedge in your portfolio. And, you will have more time to focus your efforts on other aspects related to your portfolio.
Adapt to Market Situation
The first couple of months during the beginning of 2016 indicated that trading is likely to be volatile during course of the year. The indications were right and the markets did see a great deal of volatility. Now, the question is what does all this mean to you as an investor? This means that you should adapt to the market situation when investing in markets in other countries.
At the same time, you should keep in mind the fact that some of the best investment opportunities are offered by a few of the overseas markets. In fact, you could strive to reap benefits in the near-term through the short-term economic stimulus being employed some of the countries around the world to spur growth. On the other hand, you can also think of taking advantage of the current stock prices which are relatively attractive and set up long-term overseas portfolio allocations.
If the overall volatility in the markets continues, currency volatility can also be expected to increase. As a result, it becomes more difficult to predict the direction of price movements. As the actions of the investors often lag behind the changes happening in the markets, generating profits from investments could be a challenging task.
However, new solutions that have come about have made it possible to handle currency risk in a better manner. If you are an investor who keeps track of the currency movements, you could benefit by shifting your money between funds that are hedged and those that are not hedged. The only aspect you need to ensure is that exposure is the same for both the funds. If you are going for a long-term investment and do not want to make decisions as regards hedging, then you should consider parking funds on ETFs that are dynamically hedged.