International and Global Stock Funds
Currency Fluctuations and Their Impact on International Funds
David Dierking Oct 17, 2017
In case you are wondering whether mutual funds are right for you at all, you should read why mutual funds, in general, should be a part of your portfolio.
The Concept of Currency Risk
It is important to note that currency risk can affect both the price appreciation of a security and the dividend and interest payments it makes.
How to Hedge Against Currency Risk
Consider the PIMCO Foreign Bond Fund (Unhedged) (PFUAX) and the PIMCO Foreign Bond Fund (USD-Hedged) (PFOAX). The two funds are substantially similar, except that one is currency-hedged and the other is unhedged. The U.S. Dollar Index has fallen this year, meaning funds that are denominated in the dollar would see diminished returns due to the decline in the exchange rate. That’s what we’ve seen with these two funds in 2017, with the unhedged fund up almost 9% year-to-date, but the U.S. dollar-hedged fund up only 2%.
Be sure to check our list of currency mutual funds here.
Why Exchange Rates Might Move
- Interest rates – Higher interest rates lead to higher rates of return for investors. An increase in demand from abroad for these higher rates can translate into higher value in the domestic currency, and vice versa.
- Trade balance – The balance of trade between imports and exports can impact the supply and demand for currencies. If a country’s exports exceed its imports (or the overall pricing of exports rises faster than the pricing of imports), it can result in greater value for its currency as well.
- Public debt – High levels of government debt can have a negative impact on a country’s exchange rate. A mountain of debt can create the perception that the country is in poor financial shape and has the potential of defaulting if it accumulates debt that it can’t pay off.
- Political environment – A country experiencing political unrest or governmental instability likely makes for a less attractive investment opportunity. The markets hate uncertainty, and concerns about the political environment generally lead to lower value in the domestic currency.
The Pros and Cons of Currency Hedging
On the other hand, currency risk hedging does not eliminate some of the risks of exchange rate movements. If you hedge away currency risk, there’s still the risk that you could miss out on gains if the currency appreciates in value. It’s difficult to predict movement in exchange rates, so the risk of missing out could be costly.
Key Considerations for Investors
Another important consideration to note is that hedged funds typically cost more to operate than unhedged funds. The additional step of layering on forward contracts and managing currency positions tends to drive up expense ratios.
The Bottom Line
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