Author: Peter Brown, Managing Director
When constructing and managing an investment portfolio, many investors and even some professionals focus primarily on asset classes, geographic diversification, and industry trends. However, a critical—and often overlooked—factor that can significantly affect portfolio returns is foreign exchange (FX) exposure.
Many years back (mid-noughties) a prominent property developer in our golf club purchased a property portfolio in the USA. He packaged it as an investment to members of the club, offering three times leverage. That is, if you put up €1mio you could get €3mio exposure. (The 2mio was borrowed with the 1mio as security.)
I met him on the course one evening and he said I might be the only guy in the club that had not invested in his property deal. I said, you mean your foreign exchange deal. He didn’t understand. I told him at the time the EUR/USD exchange rate was 1.2000 and I thought it was heading to 1.6000 which would mean a 33% decline in the dollar. And seeing as his clients were leveraged three times, he would wipe out all their equity.
As you can see from the chart below that is exactly what happened.
Foreign exchange rates are notoriously volatile and very unpredictable in the short term. But long term macro-economic shifts can make the outlook more predictable. You can see from the chart major changes in value over time. Economic conditions, level of interest rates and many other factors cause these changes.
Currently the dollar is on a weakening path. Down nearly 14% year to date. There are many factors at play, Trump, US debt levels, a re-assessment of US asset exposure by foreign investors, too mention a few.
Given the size of the value adjustments in the past it would be foolish to say this move is nearly done, in fact I can see 1.3500 on the cards and that would be a 30% fall from the opening levels this year. It may take several years to see that move complete but it is a serious prospect.
It means for foreign investors in US stocks, zero to minus returns for a few years.
Passive investing in US indices is fine when the dollar is on a flat or appreciating run but a disaster when the dollar is weakening. Major players realise this and the flows from the US markets are helping drive this trend.
The message for investors is that Foreign Exchange risk is very real and should be assessed when making investment decisions. Ask anybody who bought a property in Belfast just before Brexit!
Year to date the Euro Stoxx 50 has out-performed the S&P 500 by 16% in Euro adjusted returns.
Diversification Isn’t Risk-Free
International diversification is often used to reduce portfolio risk. However, this strategy introduces FX risk. If not managed properly, currency volatility can counteract the benefits of diversification. An unhedged global equity fund may experience increased volatility simply due to currency swings, even if the underlying assets perform well.
Interest Rate Differentials and Policy Divergence
Exchange rates are influenced by monetary policies, interest rate differentials, and macroeconomic conditions. Central bank actions—like rate hikes or cuts—can cause significant FX volatility. Investors must consider how these policies affect not only asset performance but also currency exposure.
Emerging Markets: Double-Edged Sword
Investing in emerging markets can offer high growth potential, but the associated FX exposure is often more pronounced and volatile. Currency depreciation, often driven by inflation or political instability, can sharply reduce returns—even in high-performing markets. Currently EM markets are very attractive as a weaker dollar is seriously beneficial, in many cases EM countries are importers of energy (priced in dollars) and have debt in dollars.
There are several strategies investors can use to manage currency risk:
- Currency Hedging: Instruments like forward contracts, options, or currency ETFs can offset FX movements. Many international funds also offer “hedged” share classes.
- Natural Hedging: Balancing investments across multiple regions and currencies can provide a natural hedge, reducing overall FX volatility.
- Strategic Allocation: Allocating more to regions with favourable currency trends or undervalued currencies can be an opportunistic strategy, especially for experienced investors.
Final Thoughts
Ignoring foreign exchange exposure is a critical oversight in global investing. While it adds a layer of complexity, understanding and managing FX risk is essential to preserving and enhancing portfolio returns. Investors should assess their risk tolerance, investment goals, and market outlook to determine the appropriate level of FX exposure—and whether hedging is warranted.
As capital increasingly flows across borders, savvy investors must treat currency risk not just as a hazard, but as a dynamic element of the investment landscape—one that can create both challenges and opportunities.
For more information and how to avail of a complimentary financial review, email pbrown@baggot.ie
Peter Brown
Managing Director
Baggot Asset Management Limited t/a Baggot Investment Partners is regulated by the Central Bank of Ireland
CRO Number: 565467
Central Bank Ref: C143849
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