Thursday, August 07, 2014

Currency Adjusted Returns Matter When Investing In Foreign Markets

Almost a year and a half ago the Bank of Japan stated it would embark on a massive stimulus plan, i.e., quantitative easing, that would amount to the equivalent of $107 billion US dollars. Many strategists have taken a positive view of this effort by Japan to stimulate the country's economy. The near term, immediate impact to Japan's stock market at that time, the Nikkei 225 Index, was a dramatic move to the upside. As the below chart shows (two year time frame), the Nikkei was up over 80% from August 2012 through May of 2013 and the S&P 500 Index was up only 20%. However, when the Nikkei returns are converted back to the US Dollar, the Nikkei returns equal about 35%.

From The Blog of HORAN Capital Advisors

Fast forward to the end of 2013 from August 2013 and the Nikkei continued to outperform the S&P 500 Index; however, when converting the Nikkei returns to US Dollars (blue line in the below chart), the Nikkei has underperformed.

From The Blog of HORAN Capital Advisors

Many investors gain exposure to foreign markets via mutual funds or ETFs. For investors then, it is important to understand the currency hedging strategies being employed within a particular fund. If a fund had not been hedging its currency exposure in the Nikkei for a US domiciled investor, returns would have been significantly impaired.

The currency hedging issue has always been important, maybe more so today given central bank interventions. The central bank stimulus programs have resulted in weakening the currency of the central bank's country. In the case of Japan, the weaker YEN (stronger US Dollar) has negatively impacted US Dollar returns.

Also, recent media reports are touting the strong returns in "frontier" markets. For investors, they need to analyze the currency hedging strategy in the fund(s) they intend to invest in. A strong dollar relative to other currencies can significantly reduce any return advantage these non-U.S. markets may generate in their respective home country currency.

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