(09/07/11) What You Should Know About Currency Risk

It may not seem like currency risk isn’t that important to individual investors, but that’s a dangerous assumption, writes Gregg Wolper of Morningstar.com.

If you take the time to leaf through one of those big, densely written fund prospectuses that arrive in your mailbox every now and then, you’ll see a long section called "Risks" that attempts to lay out every possible way the fund could end up disappointing you.

A fund that invests in foreign securities may include "currency risk" on that list. Sometimes that idea lands under a broader discussion of "foreign investment risk."

But what is currency risk? How important is it? What steps do fund managers take to address it, and how should individual investors think about it?

How Currency Moves Affect Returns
Currency strategies can be complex. In the prospectus sense, however, currency risk is straightforward: It means that currencies rise and fall over time.

If you own securities denominated in foreign currencies, when those currencies lose value versus the US dollar, you’ll get lower returns from the securities than if the currency values had stayed flat or risen. For example, shareholders of a stock fund that has not hedged its currency exposure could lose money even if the stocks in the fund’s portfolio rise in the local market.

It can work the other way as well. If foreign currencies are strong versus the dollar, as nearly all were in the first half of 2010, then shareholders of unhedged funds get an extra bonus.

How Funds Cope With Currency Risk
Most fund firms don’t offer pairs that are equivalent in nearly all respects, save currency exposure. In fact, on the stock side, very few funds are fully hedged into the dollar. It’s much more common for international stock funds to be completely unhedged.

The reason is that managers typically say they would rather concentrate on stock selection, or investigate sector or regional themes, rather than try to guess where currencies are going.

Many fund firms also say that their shareholders have told them one reason they own international funds is to get foreign-currency exposure for diversification purposes. Such shareholders don’t want any hedging.

That said, occasional hedging has become more common in recent years. For example, at a certain point a fund manager may think the pound has become far too strong, given current economic conditions and historical range.

So the manager will hedge that exposure until the pound falls to a more reasonable level (he hopes). At that juncture, he’ll revert to an unhedged stance.

Other managers may like a particular country’s stocks partly because they expect its currency to fall, giving its exports an advantage. So, they’ll buy the stocks, but hedge the currency exposure.

In fact, managers who don’t even have a particular view on a currency’s direction might hedge some of their exposure to it if they have a substantial overweighting in the country’s stocks. They would take this step to ensure that their bet is on the stocks in which they have confidence, and not the currency, which they don’t consider their area of expertise.

NEXT: From the Individual Investor’s Perspective

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From the Individual Investor’s Perspective
It’s important, therefore, for investors to understand the impact of owning foreign currencies. At times, you will end up on the short end.

However, it would be wrong to fixate on that side of the equation. In many years, rising foreign currencies add to the return provided by the foreign stocks or bonds alone.

In that sense, it’s worth considering that having no exposure to foreign currencies creates a risk of its own. In spite of this year’s rise in the dollar, many observers think there’s a danger that the dollar will resume a long-term slide as soon as panic over issues such as the European debt crisis abates.

By boosting the returns of international investments, having exposure to the rising values of foreign currencies (should that be the more enduring trend) can help offset the higher costs such a trend would impose on US residents who buy imported goods and take overseas vacations.

While shareholders of foreign-stock or foreign-bond funds likely already have foreign-currency exposure, some may want additional currency exposure without the added variable of the stock and bond movements. After all, if you think foreign currencies are going to rise and are proved right, it would be disappointing to have that advance offset by falling stock prices.

Such investors can opt for forward contracts or set up bank accounts abroad, but those can be complicated to create and maintain. A less cumbersome alternative is to choose from among the host of exchange-traded currency funds that have sprung up in recent years.

Take care when considering such investments, though. Trying to time currency movements is a tricky game, often foiling even those who spend all their time studying such things.

There’s a reason so many smart international managers don’t even attempt to make currency guesses, or do so sparingly.

Know the Landscape
If you’re aware of the effects of currency factors and know how your funds approach the issue, then when an unhedged fund suffers or benefits from currency movements, you won’t be puzzled or surprised. You won’t wonder why your fund is performing so differently from the local stock indexes.

Moreover, armed with that knowledge, you can take some control over an aspect of investing that otherwise can seem like a mysterious and powerful force in whose presence you simply must submit.

When buying international funds, you can specifically choose those that don’t hedge—or ones that do. You can choose to leave such decisions up to the manager. Or you can invest in foreign-currency funds, even picking specific currencies and avoiding others if you feel confident in taking such a course.

Knowing the landscape and making conscious choices doesn’t guarantee that the winds will blow in your favor. But at the very least, it can reduce your level of fear and frustration in an arena that is all too prone to both.