Currency risk for non-US investors

 describes how currency risk affects non-US investors, whether to protect against it, and if so then how and when, and the reasons why a given index ETF's (exchange-traded fund) performance over time often appears to differ from the performance of the index it tracks.

Currency risk
Currency risk is the way varying currency exchange rates affect returns from investing in foreign assets. If an investor's home currency weakens, that is, if it falls relative to the currency of the assets, then these investments become worth more of the home currency. Conversely, if the investor's home currency strengthens, these investments effectively lose value.

It is important to uncover only the real currency risk. For example, for an Ireland domiciled ETF traded in Euros (EUR) but holding only US stocks, the currency risk is between only the investor's local currency and US dollars (USD). That is, it is the currency of the assets that the ETF holds, not the ETF's trading or denomination currency, that matters. For a UK investor using this ETF, they are affected only by the USD to Sterling (GBP) exchange rate. For a Bulgarian investor, only USD to Bulgarian Lev (BGN) would matter. For a Norwegian investor, only USD to Norwegian Krone (NOK). And so on.

Investor returns on foreign assets
For an investor holding foreign assets, their return is the sum of
 * the return of the underlying assets, and
 * any gain or loss in the exchange rate between their home currency and the currency (or currencies) of the foreign assets.

To understand this, first imagine an ETF that holds nothing but USD actual physical cash, in a large vault of US dollar banknotes somewhere. This ETF trades in EUR, and an EUR investor buys €100 worth of shares. Over time, the USD strengthens relative to the EUR by 5%. This investor's holding is now worth €105, even though the assets the ETF holds have not changed in USD terms.

Now, imagine replacing the physical USD cash in this ETF with US stocks, denominated in USD and tracking the S&P 500 index. After this, the EUR investor's returns will be the return on the stocks, but with the additional component of currency gain (or loss) between the USD and the EUR. If the S&P 500 rises by 10% and the USD rises by 5% relative to the EUR, the EUR investor will register a 15% gain. Or, if the S&P 500 falls by 10% but the USD rises by 5% relative to the EUR, this exchange rate variation cushions the stock fall for the EUR investor, so that they would register only a 5% loss.

In the worst case, losses combine. For example, a 10% fall in the S&P 500 along with a 5% rise in the value of the EUR relative to the USD (or a 5% fall in the value of the USD relative to the EUR; they are the same thing) registers as a 15% loss for an EUR investor. Compare to a 10% loss registered by a USD investor.

Where an ETF contains assets from more than one foreign country, the currency risk and return is between the investor's home currency and the currency of those other countries, in proportion to the ETF assets held in those countries. For example, if 60% of an all-world index ETF is US stocks, then 60% of the currency risk (and currency gain or loss) is between the investor's home currency and the USD.

Comparing non-US domiciled ETF returns with index returns
Stock market indexes are commonly denominated in USD. This can create confusion when comparing the performance over time of a non-US domiciled ETF that is not denominated or not being viewed in USD, but which tracks an index that is denominated in USD. A common question is: "Why is the index up (or down) X%, but my index fund or ETF is up (or down) Y%?"

The main factor in the answer to this question will be exchange rate fluctuations. As shown above, the percentage change in a fund or ETF's net asset value over time is the combination of the underlying asset return and any change in the currency exchange rate between the index's currency and the fund or ETF's currency.

To see this in practice, some web sites allow you to view an ETF's performance in multiple currencies. For example, VUSA is a Vanguard Ireland domiciled S&P 500 index ETF that is traded in EUR, USD, GBP and CHF. If you view its returns using justETF in these currencies (use the currency selector pulldown menu at the top right to select the currency), then you will see different percentage returns over time, but with the return shown in USD closely matching the return of the S&P 500 index itself over the same period.

There may be other factors besides currency. For example, an accumulating ETF reinvests dividends, but a distributing one does not. You need to be sure to use the correct pairing when comparing ETFs with either total return or plain indexes. Over a short period however, perhaps six months to a year, the discrepancy across these will generally not exceed 1-2%.

Reducing or eliminating currency risk
A fund or ETF may choose to "hedge" currency risk for investors. Currency hedging means factoring out the exchange rate part of the return for investors, so that they receive only the pure percentage return from the assets the fund or ETF holds. However, currency risk is not intrinsically a bad thing; risk can bring reward. Because there is a cost to currency hedging, a currency hedged fund will usually have a slightly higher annual expense ratio (TER) than an equivalent unhedged fund.


 * For stocks, the general consensus is that unhedged funds makes most sense. The market for goods and services is somewhat global. For example, a UK car manufacturer might use parts shipped from the EU. If the GBP strengthens, EUR investors holding shares in that UK company could expect their shares to lose value in EUR terms. However, the parts the UK manufacturer uses to produce cars are now cheaper as a result of the GBP becoming stronger, so the UK car manufacturer may become more profitable. This can prevent the shares falling in EUR terms as much as might be expected.


 * For bonds however, hedging is usually preferred. The return on bonds is generally lower than for stocks, making exchange rate fluctuations proportionally more disruptive, and although the bond market itself is global, the stocks example above of exchange rate fluctuations somewhat balancing out does not apply.

If home country bonds are not a good option, and there is no bond fund that holds foreign bonds but is hedged to local currency, then an unhedged bond ETF is probably the best option. One exception to this would be where either an investor's home currency is pegged to another currency, perhaps USD, or where spending will be in another currency. In those cases, hedging to the USD or to the currency in which the money will be spent is appropriate.

The mirror image to currency hedging is to hold either a pure currency ETF, or the actual foreign currency itself. This will give investors just the exchange rate part of the return, and nothing else.