A Euro, A Yen, A Buck Or A Pound-Currency Fluctuation Explained

By: Bill Byrnes

Or a Yuan. (My apologies to all you Cabaret fans.) As a mutual fund or ETF investor you need to be aware of the currency risks you're taking when investing internationally. Is your fund hedged against the dollar or not? Do you want your fund to be hedged or not? What difference does it make to you? Let's start with the last question first.

Currencies do fluctuate in value, except for the Yuan. Its exchange rate is fixed by the Chinese government, but even the Chinese are responding to pressure to let the Yuan float upward in value against the dollar.

The dollar has declined against the major world currencies for the past seven years. Take the Euro, for example. The current exchange rate is about Euro1.00 = $1.46, a slight decline for the recent record of $1.49, but a big change from the one-to-one exchange ratio in 1999.

Any dollar based investor, such as those of us in the good ol' USA, would have seen substantial appreciation in his or her Euro dominated investments - European stocks and bonds - made a few years ago just based on currency movement (assuming the currency wasn't hedged).

The European investor who bought dollar dominated US stocks or bonds wouldn't have been so lucky. The Dow at 13,000 would have brought little joy to the Euro investor's heart since most of his or her gains would have been offset by the deprecation of the dollar versus the Euro.

There are ways to protect yourself against currency swings. You can make you international investments through a mutual fund which hedges - tries to eliminate or minimize the currency risk. No hedge is prefect and all hedges cost money which reduces your return, but a currency hedge factors out one risk, leaving you with the underlying risk of the investment, i.e., the performance of the stocks or bonds in the mutual fund portfolio.

Mutual funds disclose whether their strategy is to fully, partially or not hedge, so read up on your international fund before you invest in it. If you invest in a fund which doesn't hedge you can mitigate the currency risk by investing in an ETF which is designed to go up in value as the dollar appreciates.

Hedged or unhedged, which is right for you? It depends, first and foremost, on how much risk you want to take. Unhedged, an adverse currency swing could wipe out all the fund's portfolio gains and, particularly in a bond fund actually result in a loss. Secondly, it depends on your outlook for currency movements.

Global diversification is an essential part of your investment strategy. Like every other investment, you need to do your homework and understand how much, and what, risk you're taking.

Foreign Exchange
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