Management of Currency Risk in International Mutual Funds

International mutual funds provide an opportunity to diversify your investment portfolio by granting access to industries and economies across the globe. However, these opportunities also come with an additional layer of risk. One of the significant concerns in international investments is currency risk. Before proceeding to discuss the ways to manage this risk, let’s get a quick understanding about currency risk.

What is Currency Risk?

Also known as exchange rate risk, currency risk is a financial risk that arises from potential changes in the relative value of the currency in which the investment is denoted. If you’re investing in international mutual funds, your investments will be made in foreign currencies. Therefore, any fluctuations in the exchange rates can impact your returns.

How Does Currency Risk Impact Mutual Fund Investments?

Let’s assume an investor from the USA buys an international mutual fund dealing in Euros. If the strength of the Euro increases relative to the US dollar during the investment period, the investor’s returns will be higher when converted back to dollars. Conversely, if the Euro depreciates, the investor stands to lose out when the investment is translated back to US dollars. Therefore, the investor’s return is not just dependent on the fund’s performance but also on the exchange rate fluctuations, which encapsulates the notion of currency risk.

Methods of Managing Currency Risk in International Mutual Funds

Mutual Fund Currency Hedging

One of the commonly used methods to mitigate currency risk by mutual funds is currency hedging. In simple terms, currency hedging involves taking an equal but opposite position in the currency futures market to neutralize the risk of foreign exchange fluctuation. For instance, if a US-based mutual fund owns stocks in Europe, they would be exposed to the risk of Euro depreciation. To hedge this risk, the fund could sell Euro futures. If the Euro value drops, the profit from the futures contract offsets the loss in the value of European stocks.

Currency Diversification

Another strategy is through diversification, not just of asset classes but also of currencies. Investing in mutual funds that have exposure to multiple currencies can dilute the risk associated with any single foreign currency. It follows the basic investment principle that not “putting all your eggs in one basket” can help limit your losses.

Currency Overlay

Institutional investors primarily use currency overlay as a risk management strategy. In this approach, the fund manager actively manages the fund’s currency exposure separately from the investment decisions. This is usually done by hiring a separate manager known as the ‘overlay manager’. It allows the fund manager to focus on picking the right securities, while the overlay manager handles the currency risk separately.

Role of Fund Managers in Minimizing Currency Risk

A skilled fund manager plays a vital role in navigating the turbulent waters of currency risk. Through extensive macroeconomic analysis, geopolitical risk assessment and careful consideration of global events, they determine the fund’s currency exposure and take necessary steps to mitigate risk. Fund managers may adjust their strategy based on anticipated shifts in exchange rates.

Investor’s Responsibility for Currency Risk Management

While the responsibility for managing currency risk largely falls on the fund manager, as an investor, you aren’t completely absolved of duty. It’s recommended to maintain a diversified portfolio across various geographical locations and industries. Furthermore, understanding the fund’s strategy towards currency risk and considering the potential impact of currency risk on your personal investment objectives can put you in a stronger position.

The Bottom Line

Currency risk is a sizable component of the increased risks that come with international mutual funds, which enable investors to access foreign markets and wealth. A combination of strategies like currency hedging, diversification and currency overlay can minimize the adverse impacts of currency risk. Moreover, the knowledge and skillset of a competent fund manager when assessing these risks can make a significant difference. As an investor, understanding the currency risk factors and strategies to counter them will allow you to make informed decisions.