|Type of security||S&P 500 Index||Russell 2000 Index||Russell 2000 value||MSCI EAFE||International Small Cap||International Small Cap Stock||MSCI Emerging Markets|
|Russell 2000 value||0.694||0.927||1||–||–||–||–|
|International Small Cap||0.432||0.466||0.414||0.857||1||–||–|
|International Small Cap Stock||0.41||0.411||0.414||0.831||0.97||1||–|
|MSCI Emerging Markets||0.59||0.634||0.586||0.582||0.53||0.512||1|
Source: Dimensional Fund Advisors
The combination of foreign and domestic assets generally has a magical effect on long-term returns and portfolio volatility; however, these benefits also come with some underlying risks.
International Investment Risks
Several levels of investment risks are inherent in foreign investment: political risk, local tax implications and exchange rate risk. Currency risk is particularly significant because the returns associated with a particular foreign stock (or mutual fund with foreign stocks) must then be converted into US dollars before an investor can spend the profits. Let’s break down each risk.
- Portfolio risk
The political climate of foreign countries creates portfolio risks as governments and political systems are constantly changing. This usually has a very direct impact on the economic and commercial sectors. Political risk is considered an unsystematic type of risk associated with specific countries, which can be diversified by investing in a wide range of countries, effectively achieved with broad-based foreign mutual funds or exchange-traded funds ( AND F).
Foreign taxation poses another complication. Just as foreign investors holding US securities are subject to US government taxes, foreign investors are also taxed on foreign securities. Taxes on foreign investments are usually withheld in the country of origin before an investor can make any gains. The profits are then taxed again when the investor repatriates the funds.
- Risk of change
Finally, there is the currency risk. Fluctuations in the value of currencies can have a direct impact on foreign investments, and these fluctuations affect the risks of investing in non-US assets. Sometimes these risks work in your favor, other times they don’t. For example, suppose your foreign investment portfolio generated a 12% rate of return last year, but your home currency lost 10% of its value. In this case, your net return will be improved when you convert your profits to US dollars, because a falling dollar makes international investments more attractive. But the reverse is also true; if a foreign stock declines but the value of the domestic currency strengthens sufficiently, this further dampens the returns of the foreign position.
Minimize currency risk
Despite the perceived dangers of foreign investments, an investor can reduce the risk of loss from exchange rate fluctuations by hedging with currency futures. Simply put, hedging is taking one risk to offset another. Futures contracts are anticipated orders to buy or sell an asset, in this case, a currency. An investor who expects to receive cash flows denominated in a foreign currency at a future date can lock in the current exchange rate by entering into an offsetting forward currency position.
In foreign exchange markets, speculators buy and sell currency futures to profit from changes in exchange rates. Investors can take long or short positions in the currency of their choice, depending on how they think that currency will behave. For example, if a speculator thinks the euro will rise against the US dollar, he will enter into a contract to buy the euro at a predetermined time in the future. This is called having a long position. Conversely, you could argue that the same speculator took a short US dollar position.
There are two possible outcomes with this hedging strategy. If the speculator is right and the euro rises against the dollar, the value of the contract will also rise and the speculator will make a profit. However, if the euro falls against the dollar, the value of the contract decreases.
When you buy or sell a futures contract, as in our example above, the price of the good (in this case, the currency) is fixed today, but payment is not made until later. Investors trading currency futures are asked to set up margin in the form of cash and the contracts are marked to market daily, so profits and losses on the contracts are calculated daily. Currency hedging can also be done in a different way. Rather than locking in the price of a currency for a future date, you can buy the currency immediately at the spot price. In both cases, you end up buying the same currency, but in one scenario, you are not paying for the asset up front.
Investing in the currency market
The value of currencies fluctuates with global supply and demand for a specific currency. The demand for foreign stocks is also a demand for foreign currency, which has a positive effect on its price. Fortunately, there is an entire market dedicated to foreign currency trading called the foreign exchange (forex, for short) market. This market does not have a central market like the New York Stock Exchange; instead, all business is conducted electronically in what is considered one of the largest liquid markets in the world.
There are several ways to invest in the forex market, but some are riskier than others. Investors can trade currencies directly by creating their own accounts, or they can access currency investments through forex brokers.
However, forex trading with margin is an extremely risky form of investment and is only suitable for individuals and institutions who can handle the potential losses it entails. In fact, investors looking for exposure to currency investments might be better served by acquiring them through funds or ETFs, and the choice is vast.
Some of these products make bets against the dollar, some bet in favor of it, while other funds simply buy a basket of world currencies. For example, you can buy an ETF consisting of currency futures contracts on certain G10 currencies, which can be designed to exploit the trend that currencies associated with high interest rates tend to rise in value against currencies associated with low interest rates. Things to consider when incorporating forex into your portfolio are costs (trading fees and fund fees), taxes (historically, investing in forex has been very tax inefficient) and finding the appropriate allocation percentage.
Investing in foreign stocks has a clear advantage in portfolio construction. However, foreign stocks also have unique risk characteristics that US stocks do not. As investors expand their investments overseas, they may wish to implement certain hedging strategies to protect themselves from continued fluctuations in currency values. Today, there is no shortage of investment products available to help you easily achieve this goal.