While investing internationally is important to having a diversified portfolio, it’s not likely to get any easier this year. As world monetary policy continues to diverge — in other words, Europe and Japan remain committed to rock bottom interest rates while the U.S. Federal Reserve raises ours — expect currencies to continue their bumpy ride.
Looking at volatility in the past year on the DXY index, which is a measure of the value of the U.S. dollar relative to a basket of major foreign currencies, we’ve seen an increase from 6% to 12%. And it’s becoming increasingly difficult to predict whether it will go up or down.
In The BlackRock List, we describe why we believe the U.S. dollar will remain strong in 2016 amid global market volatility. While we see potential opportunities abroad, we suggest that American investors think about how to mitigate currency risk in their overseas investments.
Zigging When You Should Be Zagging
What you see above relates directly to your international portfolio returns, because when you invest in a foreign market, you are usually also investing in that foreign currency. Think of it as a simple equation:
This equation tells us that exchange rate movements have the potential to either add to the returns in a portfolio or diminish them — and in the worst case scenario, they may even lead to losses.
Last fall, I shared considerations for building a currency hedged strategy. Being hedged — or basically taking the exchange rate effect out of the equation — at the right times can really make a difference in the performance of your portfolio.
The truth is that timing currency movements is not an easy task, and data shows us that investor decision-making often lags market developments. In other words, many investors often buy and sell at the wrong times. This can happen in any part of the market, not just with currencies. However, the volatility inherent in currencies makes it critical to make the right decision at the right time. Take a look at the disconnect between the strength of the U.S. dollar v. the Japanese yen and flows into currency hedged funds since April 2014.
So, the real question is whether you feel confident in your ability to predict currency movements in an increasingly volatile world. If the answer is yes, then using traditional fully hedged exchange traded funds (ETFs) may be the right tool for targeting specific short-term opportunities or seeking to take currency entirely out of the equation.
If the answer is no, then the new iShares adaptive currency hedged ETFs may provide a good solution for longer-term allocations to developed international markets, Europe and Japan. With these ETFs, investors don’t need to figure out when and how much to hedge foreign markets as they are designed to dynamically adjust to changing currency environments. They take the guesswork out of managing a currency hedge in your portfolio, freeing up your time and effort to focus on other areas of your portfolio.
Adapt to Market Reality
If the first couple months of the year are any indication, it looks like 2016 will be a volatile year. So, what does that mean for investors? Let’s recap the reality of investing in today’s global markets:
- We continue to believe that some of the best opportunities lie abroad. Investors may seek to benefit from near-term economic stimulus in many countries, or they may want to take advantage of relatively attractive stock prices and establish long-term international allocations.
- As overall volatility in the markets continues, we expect currency volatility to increase and therefore become more difficult to predict. Unfortunately, many investors’ actions tend to lag the changes in the market.
- New solutions have made it easier than ever to address currency risk. Shifting between hedged and unhedged versions of the same exposure is a great way to take currency risk on and off, assuming you have a view on currency. If you’re investing for the long-term and prefer to not make hedging decisions, you may want to consider a dynamically hedged ETF.