The explosion of exchange traded funds (ETFs) has allowed individual retail investors the ability to bet a variety of new asset classes. From commodities to non-traditional fixed income sectors like preferred stocks and convertible bonds, ETFs have changed the playing field for the little guy. One area that has seen tremendous growth is international equities.
There are now countless funds that track such faraway markets like Greece, Brazil and even Indonesia. Going global in a portfolio has never been easier.
However, as investors have plowed some big dollar amounts into these international equity funds, they might not realize just how their returns can be influenced by how foreign currencies perform against the U.S. dollar. Rising and falling, pounds, euros, ringgits and rupees have a huge effect on whether or not investors will see strong returns.
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Closet Forex Traders
The foreign exchange or forex market is the largest and most liquid of all markets, moving nearly $3 trillion worth of "asset" each day. Most normal investors try to stay away directly from the 24-hour world of pips, convertible and base currencies as forex trading generally involves some big risks. However, exposure to exchange rates is not reserved for those trading in ultra-leveraged forex accounts. The reality is that the vast majority of investors maintain significant exposure to international currencies in their portfolios. Indirectly, almost all investors can call themselves currency traders by some measure.
That's because when they go long on an international equity ETF, many investors often do not realize that there is a two-part total return element to foreign assets - how the stock performs in its local currency and how that currency performs relative to the dollar. For example, going long in Brazilian equities via the iShares MSCI Brazil Index ETF (ARCA:EWZ) inherently includes a long position in the Brazilian real relative to the U.S. dollar. If the Brazilian currency appreciates, the returns realized by U.S. investors will be enhanced. That was the case back in 2010 and 2011, as U.S. investors saw a big bump in returns due to the strong Brazilian real.
However, this effect can work both ways. Returns of EWZ in the past year have suffered as the Brazilian central bank has favored a weakened real and a stronger U.S. dollar to increase exports. Local Brazilian investors realized returns at roughly 11%, while U.S. investors owning Brazilian equities actually saw a loss for the year.
SEE: The Fallacy Of International ETFs
In addition, total returns for an international ETF can also be affected by various currency shifts. Investors can gain or lose based on any dividends paid by the underlying stocks within the index or ETF. As dividends are paid in kiwis, loonies or baht and then translated back into U.S. dollars, there again exchange rates can have a dramatic effect. Strong U.S. dollar versus your Canadian ETF? Expect less income from the fund. On the flipside, a weak U.S. dollar means ETFs like the PowerShares International Dividend Achievers ETF (ARCA:PID) could provide a nice income bump as the greenback falls.
Add these dividends back into how the ETFs' assets perform versus the U.S. dollar and you have a recipe for varied total returns.
Look Before You Leap
The abject lesson in all of this is that most investors already have enough currency exposure within their international holdings and may not need to directly participate in the forex market at all. Going long a fund like the iShares MSCI Sweden Index ETF (ARCA:EWD) and the CurrencyShares Swedish Krona Trust ETF (ARCA:FXS) at the same time means portfolios could be impacted by the same changes in different funds. Investors need to look at how their ETF portfolios work in concert before adding assets for the sake of it.
On the flip side, investors who want to take currency out of the equation from their foreign investments altogether have a few choices from WisdomTree. Both the WisdomTree Japan Hedged Equity ETF (ARCA:DXJ) and the WisdomTree Europe Hedged Equity ETF (ARCA:HEDJ) use derivatives to smooth out the currency bumps in each fund. This provides a "pure" return of the underlying equities. DXJ is proving to be quite popular versus its larger competitor - the iShares MSCI Japan Index ETF (ARCA:EWJ) - in the current falling yen environment.
SEE: 7 New ETFs for International Exposure
The Bottom Line
With international equity ETFs popping up in almost every portfolio these days, many investors are blissfully unaware of the effects that currency exchange rates have on their total returns. The truth is, those relationships between the dollar and various other currencies can make or break a portfolio's total return. Investors just need to do their homework before adding funds like the WisdomTree Brazilian Real ETF (ARCA:BZF) to their portfolios.
At the time of writing, Aaron Levitt did not own any shares in any company mentioned in this article.
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