International ETFs; Minus The Currency Risk

Ron Rowland:  Have you noticed how the best-performing ETFs and mutual funds often specialize in international stocks? Funds focused on emerging markets, Asia/Pacific, China, Brazil and many others dominate the top of almost any long-term return rankings. Why?

You might think it is because foreign markets have outperformed the U.S. That’s true in some cases — but by no means always. There’s another reason, too.

If you are a U.S. investor, your return from non-U.S. investments will reflect the performance of the market you buy and any movement in the foreign market’s currency vs. the U.S. dollar. As we will see, the consequences can be dramatic.

How a Falling Greenback Helps Investors

Many Americans ignore currency fluctuations. Unless you live overseas or frequently travel outside the country, you probably don’t notice if the dollar goes up or down vs. other currencies.

Americans notice other currencies mainly when  travelling.
Americans notice other currencies mainly when travelling.

But the financial markets do take notice, and it makes a difference to your bottom line. Let’s step through an example …

Suppose you invest $1,000 in Japanese stocks (or an ETF that does it for you). Your dollars are converted to yen at that day’s prevailing rate, and then used to buy shares in Tokyo. We’ll assume the exchange rate was 100 yen for a dollar, and the stock cost 250 yen per share. Ignoring transaction costs, your $1,000 became 100,000 yen, netting you 400 shares.

Now, let’s assume two things happen:

First, the value of your Japanese stocks goes sideways. You paid 250 yen per share, and the price is still 250 yen per share a year later.

Second, the greenback gets weaker, forcing the exchange rate up 5 percent over the same year. So now it costs $1.05 to buy 100 yen.

In this scenario, your stocks went nowhere, but your $1,000 investment is now worth $1,050. Why? Because it now takes more dollars to get the same quantity of yen. Your 400 shares at 250 yen are still worth 100,000 yen, but when you convert it back to dollars it becomes $1,050.

I know this may be a bit hard to grasp. Here’s the bottom line: If your home currency loses value against the local currency in which you invest, you can show a profit even if your foreign investment goes nowhere!

In other words, investing outside the U.S. involves a type of leverage. And similar to a margin account, the leverage can work either for you or against you.

For instance, if your chosen international market gains in value, and its currency also gains in value, you get the benefit of both.

[Editor’s note: Buying an international ETF that’s soaring is one thing. Converting your paper profits into tangible, money-in-the-bank profits is quite another! To watch Ron’s presentation on how he does this for his International ETF Trader members, click here.]

However, if your chosen international market loses value, and its currency also loses value, your losses will be magnified accordingly.

This is why international ETFs are often more volatile than domestic ones. The currency exposure gives you a whole new way to gain or lose value.

In the case of Japan, the difference over a decade has been huge. The MSCI Japan Index had a ten-year annualized return (as of 6/20/11) of -0.21 percent in U.S dollar terms. A yen-based investor who bought the very same index had an annualized return of -4.41 percent.

Which Way for the Dollar?

The U.S. dollar trended steadily down for most of the past decade. Yes, we saw some periods of dollar strength, but for the most part the dollar got weaker and weaker.

Regardless of who was in control, the Fed and the Treasury have done all they can to weaken the dollar. Their reasoning: A weaker dollar makes U.S. exports cheaper, thereby helping American businesses compete with foreign companies.

I don’t know if the authorities will continue pushing the dollar lower. At some point, they may reverse course. We can’t presume international ETFs will always have currency trends to help. So how does this affect your ETF investments?

Presently, almost all international ETFs reflect both the performance of their targeted stock market and changes in the foreign exchange rates. You can’t have one without the other.

This is starting to change …

International ETFs without Currency Risk

ETF sponsors have launched several ETFs that attempt to “hedge” currency movements right out of the equation. WisdomTree International Hedged Equity Fund (NYSE:HEDJ) has been the only ETF that strips out the effects of foreign currencies since its launch in 2009.

However, just last week, Deutsche Bank decided to join in and launched five new ETFs for this very purpose.

  • db-X MSCI EAFE Currency-Hedged Equity Fund (DBEF)
  • db-X MSCI Emerging Markets Currency-Hedged Equity Fund (DBEM)
  • db-X MSCI Brazil Currency-Hedged Equity Fund (DBBR)
  • db-X MSCI Canada Currency-Hedged Equity Fund (DBCN)
  • db-X MSCI Japan Currency-Hedged Equity Fund (DBJP)

If they achieve their objectives, these ETFs will reflect the change in their respective specialties without any help (or drag) from the U.S. dollar.

Of course I don’t know if they will perform well — just as I don’t know what the future holds for the greenback. I mention them so you will know such ETFs are available. Your toolbox is getting bigger all the time!

Best wishes,

Written By Ron Rowland From Money And Markets

Money and Markets (MaM) is published by Weiss Research, Inc. and written by Martin D. Weiss along with Nilus Mattive, Claus Vogt, Ron Rowland, Michael Larson and Bryan Rich. To avoid conflicts of interest, Weiss Research and its staff do not hold positions in companies recommended in MaM, nor do we accept any compensation for such recommendations. The comments, graphs, forecasts, and indices published in MaM are based upon data whose accuracy is deemed reliable but not guaranteed. Performance returns cited are derived from our best estimates but must be considered hypothetical in as much as we do not track the actual prices investors pay or receive. Regular contributors and staff include Andrea Baumwald, John Burke, Marci Campbell, Selene Ceballo, Amber Dakar, Maryellen Murphy, Jennifer Newman-Amos, Adam Shafer, Julie Trudeau, Jill Umiker, Leslie Underwood and Michelle Zausnig.

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