Planning matters

“Cambio, Change, Wechsel”

Foreign Exchange Office Sign

The site of these three words remind me of travel to foreign countries, and of course, foreign “exchange”.

However, for many people, foreign exchange (currencies) might be, after gold, the most misunderstood and confusing asset in the world. Why, for example, is the Japanese yen quoted yen per U.S. dollar while the euro is quoted as U.S. dollar per euro?

Japanese Yen 103.04
Euro 1.1137

Source: WSJ, as of 11.4.2016

I’m not exactly sure why, but what I do know is foreign currencies are a critical element in any global investment portfolio. Therefore, it makes sense to understand the basics of currency risk in any stock/bond portfolio.

U.S. stocks represent about 56% of world market capitalization while foreign stocks represent about 44%. Vanguard’s Total World Stock ETF (VT) tracks an index of investable stocks within this universe, meaning foreign currencies (representing 44% of all stocks held) help to drive or detract from the return of the fund.

To understand the power of the relationship between currencies and foreign stock funds, let’s use a recent example of the performance of British stocks versus the British pound post “Brexit”.

chart
Source: Stockcharts.com. London Stock Exchange. 6.27.2016 – 11.4.2016. British stocks represented by the FTSE 100.

British stocks rallied 5.60% from their lows, however, the pound lost 14.35%, which wiped out way more than the entire gain in UK shares. So, as a U.S. investor, currency risk (or direction) is equally as important as the investment merits of any foreign stock market.

Let’s examine foreign bonds, where bonds can be issued in local currency and/or in U.S. dollars. For example, in emerging markets (EM), local currency bonds typically have a higher interest rate than a U.S. dollar-based bond. The higher interest rate in local currency helps to compensate for the currency risk, but investors must be diligent to manage currency risk in addition to credit, and interest rate risk when investing outside the U.S.

Let’s look at the example of the Pimco Local Currency Bond Fund (PELBX), which invests in EM local currency bonds, and the Pimco Emerging Markets Currency Fund (PLMIX), which invests in a basket on EM currencies. The table below shows the year-to-date returns of the local currency bonds along with the local currencies.

Pimco Local Currency Bond Fund 17.41%
Pimco Emerging Markets Currency Fund 9.55%

Source: Pimco, return data is YTD to 11.8.2016

The bond fund returned 17.41% with the currency component explaining approximately 9.55% of the return. In other words, the appreciation of the local currencies drove over half of the return in the bonds and highlights the significance of the currency component in any foreign bond fund. The remaining component of the bond fund’s return is attributable to both price movement and cash flow yield (or coupon) of the bond(s).

In summary, foreign stocks and bonds are an integral part of any global asset allocation. Because of the currency component, these assets can provide a unique and meaningful source of returns not available in a domestic (U.S. based) portfolio. However, it’s important to understand that currency risk works both ways, helping to add or detract from total return. As with any investment, having a long-term time horizon for these types of assets allow for periods of outperformance versus U.S. dollar based investments alone.

Disclosures:
The information presented herein has been obtained or derived by sources believed to be accurate and reliable. This document has been provided to you solely for information purposes and does not constitute an offer or solicitation of an offer, or any advice or recommendation, to purchases any securities or other financial instruments, and may not be construed as such.
The investment strategy, views, and themes described herein may not be suitable for all investors.
All opinions expressed are those of the author and are current only as of the date appearing on this material.
There is risk of substantial loss associated with trading equity, currency, interest rate and commodity-related futures, options, derivatives and other financial instruments. Before trading, investors should carefully consider their whole financial position and tolerance for risk, and determine if the proposed trading style and investment strategy is appropriate.
The performance results contained herein do not reflect the deduction of transaction costs and other fees that may be associated with investing, such as brokerage or advisory fees. Past performance is not an indication of future results, and should not be construed as such.