Systematic Relative Strength

You probably are-you just don’t know it. Investors, whether they own domestic or international securities, have currency exposure. If you own U.S. stocks, you are effectively long dollars. Instead of being oblivious to your exposure, Morningstar argues that it is important to pay attention to it:

…it would be useful to evaluate the implicit currency bets that might already be lurking inside your portfolio. U.S.-based investors who own non-U.S. assets most likely already have sizable exposure to foreign currencies. Remember, the total return of foreign assets is composed of two parts: its local price return and the currency’s change relative to the greenback over the investment period. As international stock and bond allocations make up bigger and bigger slices of many investors’ portfolios, it becomes increasingly important to recognize and understand the impact that currency exposure can have on your portfolio’s risks and returns.

Consider a few examples. In local currency terms, the MSCI Australia Index returned roughly 32% from the start of 2009 through mid-April, but in U.S. dollar terms the return was well over 70%. Over the same period, we saw similar cases with Brazil and Canada. The local returns for the MSCI Brazil Index and the MSCI Canada Index were about 54% and 31%, respectively. In U.S. dollars, however, Brazil more than doubled and the Canadian index enjoyed a return of approximately 60%.By the same token, a strengthening U.S. dollar relative to a foreign currency would be a drag on the total return of unhedged international stocks. We saw this back in 2005 when the greenback was strengthening against most other currencies. For instance, the local market return for the MSCI UK Index in 2005 was 20.1%-not too shabby. But the pound sterling lost nearly 13% of its value against the U.S. dollar, leaving U.S.-based investors with a total return of 7.4%. Similarly, the local currency MSCI Japan Index rose 44.6% in 2005, but because the yen lost roughly 19.1% relative to the greenback over the same period, U.S. investors enjoyed a return of “only” 25.5%.

As the above examples illustrate, it can be critically important to understand the source of your investment returns.

That puts a little different perspective on it! Your investment returns can be radically affected by currency translation, so it behooves you to pay attention to it. Relative strength is a fruitful way to stay in tune with currency effects. For example, both Australia and Brazil are currently held in the international sleeve of the Arrow DWA Balanced Fund (DWAFX)-not because we made a correct currency forecast, but simply because the currency exchange really added to the relative strength rankings of these two markets.