Managing Currency Risk: Practical Guide to Building a Globally Diversified, Multi-currency Investment Portfolio

Part 2: Practical Guide to Building a Globally Diversified, Multi-currency Investment Portfolio

Introduction

Currency issues are often one of the most vexing and least well understood issues for investors. This is especially true for Americans abroad whose salaries and other income sources are often denominated in currencies other than U.S. Dollars (USD). The good news is that understanding how to properly incorporate currency considerations into a sound, long-term investment strategy is much easier than commonly understood. In part 1 of this two part series, we discussed principles of sound currency management in investing. In this part 2 below, we provide a practical guide on how and where investors can go to construct a globally diversified, multi-currency investment portfolio.

How to build a diversified, multi-currency investment portfolio: the practical issues

In part one of this two part series, we have identified the idea of "matching assets to liabilities" as a logical, systematic framework from which we can determine the proper currency mix needed in our investment portfolio. But are not multi-currency portfolios the exclusive realm of the ultra-wealthy who have accounts all around the globe? Do we have to open up investment accounts in the U.S. AND Europe or buy complicated currency hedging products, such as futures or swaps? Or do we need to employ the help of an expensive Swiss investment bank which can buy securities on any global exchange and in any currency, do all the required currency conversions and simultaneously report in three or more different currencies?

The answer to these questions is categorically NO. The globalization of finance and the development of highly efficient and inexpensive investment tools such as Exchange Traded Funds (ETFs) allow us to build a fully diversified, multi-currency portfolio right in our IRA or brokerage account at any of the big U.S. brokerage firms, such as Charles Schwab, Fidelity or E*Trade. For Americans, not only is this much less costly and complex option now fully viable, but for reasons having to do primarily with U.S. tax law, it is absolutely imperative that American citizens do all their investing through U.S. financial institutions (on this point, see the Thun Research report Six Reasons Americans Abroad Should Keep Their Money On-Shore and in the U.S, available at www.thunfinancial.com).

Investors often confuse the currency denomination of their brokerage firm account statement or even the currency denomination of a mutual fund or ETF that they own in the account with the currency exposure of their actual investments. But the currency denomination of the account statement or even the fund itself is irrelevant. It is merely a convenience for the exchange where the ETF is traded or for the brokerage firm that does not want to report in more than one currency. The investor's actual currency exposure is determined by the underlying investments in the account or held by the fund or ETF owned through the account.

Example: Two different currencies, two different exchanges, same investment

Let's consider the example of an American investor living in Denmark who wants to buy a basket of European stocks as a long-term euro denominated stock market investment. A European broker might advise him to buy the Dublin, Ireland listed, euro-denominated ETF, ticker symbol EUE. EUE invests in a basket of stocks based on the EURO STOXX 50 Index (50 large European companies). That would indeed give the investor solid exposure to a well diversified list of top European company shares.

However, the American investor could also have taken his money, converted it to dollars and through a U.S. broker bought a virtually identical investment: a New York listed, dollar denominated ETF, ticker symbol FEZ. FEZ is based on the same EURO STOXX 50 Index and therefore holds the same basket of European company stocks.

In this case, even though the ETFs are denominated in different currencies, the underlying investments held by the two ETFs are identical and have the same currency denomination (euro). The currency denominations of the ETFs are just a convenience for the New York or Dublin exchanges. It does not change the currency denomination or any other characteristics of the underlying investments held by the ETFs. Therefore, the performance of the investments will also be identical. To compensate for the change in exchange rate, the returns of each ETF, measured in their own currency, will differ by an amount exactly equal to the change in the exchange rate. Hence, owning either the euro denominated ETF or the USD denominated ETF will result in an equivalent investment return. (It is important to recognize that this is in contrast to the CD example provided earlier. In that example, the underlying investments, the CDs themselves, were denominated in different currencies and hence were fundamentally different investments and had different investment outcomes.)

To demonstrate this conclusion, we tracked the performance of the two funds over the period December 31, 2005 to December 31, 2010. We found that FEZ (the USD ETF) gained a total of 3.4% while EUE (the Euro ETF) lost 8.7%. That is to say that the USD denominated FEZ outperformed its euro cousin, EUE, by 12% over the period. Over the same period, the USD declined 12% against the euro (from 1.18/€ to 1.32/€). Therefore, the investment performance difference between the two funds is exactly offset by the change in the currency over the period. At the end of the period, both investments are worth precisely the same amount, whether expressed in USD or euros. Hence, it made no difference from an investment performance point of view if the investor bought the euro ETF from a European broker or the USD ETF from a U.S. broker. This result is what we expected, for reasons discussed above. We reiterate that what matters is not the currency denomination of the ETF, but the currency denomination and nature of the investments held by the ETF.

Likewise we would find the exact same result if we compared a European stock that lists both in Europe and the U.S., as most major stocks do. For example if we look at the shares of British Petroleum (BP) we will see that the difference in performance between London listed BP shares and the New York listed BP shares exactly matches the change in the value of the pound versus the dollar over the period examined. Again, we see that it does not matter whether you pay BPS to buy a British stock on a UK exchange or pay USD to buy the same British stock on an American exchange. The investment outcome is identical because the underlying investments are identical.

Enter tax considerations and investment expenses

While ETFs that invest in the same underlying securities will generate the same return on investment no matter what the currency denomination of the ETF itself is, the tax and compliance costs make the purchase of the euro-denominated European stock ETF a much worse investment choice for American investors. For better or for worse, U.S. tax and reporting rules make the after-tax return on investment of the Dublin listed ETF much lower for American citizens than the after-tax return on the New York listed EFT. Furthermore, investment costs (fund expenses and brokerage commissions) associated with buying the European ETF will be higher or much higher in Europe than American, depending on from which country the investments are made.

Conclusion

These examples are intended to demonstrate that fully diversified, multicurrency portfolios can be easily constructed using standard U.S. investment or retirement accounts and investing in widely available, cost-efficient and liquid ETFs. Furthermore, almost all investments, no matter where the issuer is located, can be bought and sold in New York for lower cost than those same investments can be purchased in the issuer's home country. This surprising fact is another important reason that Americans abroad should do their investing through U.S. financial institutions, no matter what their currency exposure needs. Remember, what matters is not the fact that a U.S. account statement lists the value of investments in USD. Rather, what matters is the nature and currency denomination of the underlying investments.