FOR Americans with significant exposure to foreign stocks, the euro’s 16 percent decline against the dollar this year may lead to second thoughts.
After all, the same forces that led to the euro’s drop — namely, the region’s mounting debt and credit problems — have pushed European stock prices sharply lower. And the currency’s fall to $1.21 last week from $1.43 at the start of the year has only exacerbated those losses.
Although the Morgan Stanley Capital International EAFE (for Europe, Australasia and the Far East) index of foreign shares is down nearly 7 percent in 2010, the losses have been twice as large for Americans after factoring in the strengthening dollar.
But before investors start changing their portfolios because of concerns over currency risk, market strategists advise them to consider several things.
For starters, the euro has been weakening for only about seven months, a short period on which to base long-term portfolio decisions. To be sure, fears are growing that the euro could slide for several more months, and some economists say it could even fall to parity with the dollar. But remember that only six months ago, many economists were concerned about the dollar’s weakness and the euro’s strength.
And while foreign currency fluctuations have served as a headwind for Americans investing in Europe lately, they have been a tailwind for Americans investing abroad for much of the last decade.
Over the last 10 years, the EAFE index has fallen about 4 percent, annualized, in local currencies. But because the dollar was weakening against the euro and other world currencies for much of this period, Americans suffered milder losses, just 2 percent a year, on average, in EAFE stocks. This may partly explain why investors in recent years have poured more money into stock funds with mainly foreign holdings than into those that mainly hold domestic stocks.
Keep in mind, too, that while the dollar has strengthened against the euro this year, it hasn’t necessarily gained that much ground against other currencies, said Alec B. Young, international equity strategist for Standard & Poor’s Equity Research Services.
Mr. Young points out that while the dollar’s rise has been a huge burden on European stock holdings, “there’s been much less currency drag when it comes to the emerging markets.” While the dollar has risen against the Brazilian real and the South Korean won, for example, it has lost value against currencies like the Mexican peso and the Thai baht. That explains why, since the start of the year, the MSCI Emerging Markets index has lost about 6 percent in local currencies and 8 percent in dollars.
In countries like Japan and Canada, currency fluctuations have worked to the benefit of American investors. Although the MSCI Japan stock index is down nearly 7 percent this year, those losses amount to less than 5 percent when converted into dollars. Mr. Young argued that this shows the risks of abandoning a foreign investing strategy simply because of the euro’s woes.
Perhaps the best case for maintaining overseas holdings, though, is that exposure to different currencies has been shown to make a portfolio more stable, and not more volatile, in the long run.
How is that possible?
Stock markets around the world have grown more correlated, thanks to the effects of globalization. In fact, there is now a correlation level of about 0.9 between movements in the Standard & Poor’s 500 index of domestic stocks and the EAFE. (A correlation of 1.0 would indicate that two investments were in perfect sync.)
But Peng Chen, president of Ibbotson Associates, the investment advisory firm, notes that currency fluctuations are one aspect of foreign investing that has been shown to be essentially unrelated to movements in the S.& P. 500. In fact, over the last 20 years, the correlation between movements in European currencies and the S.& P. 500 has been just a negative 0.07, he said.
(Negative correlation implies that when the currencies rise against the dollar, the S.& P. 500 may fall, and vice versa, but the 0.07 figure is so small that the two movements can be seen as virtually independent.)
MICHELE GAMBERA, head of quantitative analysis at UBS Global Asset Management in Chicago, says that even if foreign stocks no longer zig when domestic shares zag, one reason that these asset classes don’t always post similar returns each year is the currency effect.
“By having even some passive exposure to different currencies, you are adding diversification,” he said.
Of course, this currency exposure can bolster returns in some years and hurt them in others. It’s hard to predict.
But that’s the point of diversification — maintaining broad-based exposure to various assets, even if some might lose value, because it’s impossible to tell when one investment will fare better than another.
Paul J. Lim is a senior editor at Money magazine. E-mail: fund@nytimes.com.
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