Over the past several years, much has been written about the underperformance of the U.S. stock markets relative to stock markets overseas. As this trend has unfolded, international equity mutual funds have grown in popularity among retail investors and many portfolio managers have allocated the majority of their assets to foreign markets.
It may be surprising to learn, however, that most of the outperformance of international mutual funds has been driven not by the performance of the foreign markets themselves, but by the difference in exchange rates between local foreign currencies and the U.S. dollar. When a U.S. investor invests in a mutual fund that owns international stocks, he is exposed to two sources of return: The increase or decrease in the price of the stocks themselves, and the increase or decrease of the local currency exchange rate versus the U.S. dollar. If the local currency appreciates relative to the dollar (that is, if the dollar is falling), this adds to the returns of a mutual fund that owns international stocks. If the local currency depreciates relative to the dollar, the returns of the international mutual fund are decreased by the amount of the depreciation.
Contrary to popular belief, it is the currency movements and not the performance of foreign stock markets which has mostly driven the higher returns of international funds over the past decade. When you select the link below, the chart will show that the local currency returns of developed international markets (as measured by the MSCI EAFE Index) are far more modest than their returns in U.S. dollars. CLICK HERE TO VIEW CHART
For investors who are hoping for renewed strength in the U.S. dollar, the message is clear: Be careful what you wish for. In the month of August 2008 alone, the 5% appreciation of the dollar versus the EAFE currencies turned a 1% local currency-based gain in the foreign markets into a 4% loss in dollar terms. While it is impossible to predict the movement of currency markets over the short term, it can be said with confidence that if the dollar continues to appreciate, international funds will continue to face an uphill climb versus their U.S. counterparts.
Currency exposure is a great source of diversification, but it is also a source of risk. Since U.S.-based investors have most of their expenses and liabilities denominated in dollars, it is important to maintain this currency risk at a reasonable level. This is why we currently have two-thirds of our equities and over 80% of our fixed-income allocated to dollar-denominated assets.
As always, please feel free to contact us with questions, comments or suggestions for future topics.
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