International Strategy: Understanding Currency Movements Executive Summary In the past few years, international investing or the purchase of non-u.s. securities has become increasingly popular. We believe this is for good reason. Diversifying internationally may add significant value to an investment program by potentially increasing returns, reducing volatility (risk), or both. But, investing in non-u.s. securities sometimes gives rise to certain challenges, one of which is the need to understand the potential impact of currency movements on the potential profitability of the overall investment. With low interest rates in the U.S., investors may wish to look overseas for other options. How currency movements can impact investments When considering whether or not to invest abroad, clients and their advisors often need to make two decisions, not just one. The first is the same decision that must be made when investing in the U.S. Does the security in question represent an attractive investment opportunity based on its underlying fundamentals and market conditions? When the security in question is valued in a foreign currency, there is a second decision to be made that may be of equal importance. What is the likelihood that this currency will appreciate or depreciate over time versus the U.S. dollar, and how will this affect the overall profitability of the investment? Oftentimes, this second decision is no less important that the first one. The foreign exchange market Although not always a visible factor in our everyday lives, the foreign exchange market is by far the largest exchange in the world. According to the Bank of International Settlements, average daily foreign exchange trading volume in 2010 was approximately $4 trillion per day or over fifty times the trading volume of the New York Stock Exchange. And, with the seemingly unstoppable rise of globalization among the world s major economies, currency movements are likely to become even more important in the years ahead.
Page 2 In 2010, it is estimated that the U.S. dollar was involved in 85% of foreign exchange transactions. But other currencies are actively traded as well. Currency Distribution of Global Foreign Exchange by Market Turnover* Currency 2010 % of Daily Turnover U.S. Dollar 84.9 Euro 39.1 Japanese Yen 19.0 British Pound Sterling 12.9 Source: Triennial Central Bank Survey of Foreign Exchange and Derivatives Market Activity *Because two currencies are involved in each transaction, the sum of the percentage shares of individual currencies totals 200% instead of 100%. This list is not exhaustive. Over 30 currencies make up the remaining 44.1%. Foreign currency exchange rates Very simply, a foreign currency exchange rate is the cost of a unit of foreign currency in terms of the domestic currency. While most currencies are quoted in terms of U.S. dollars (i.e. the price of a unit of foreign currency in U.S. dollars), the Japanese yen is usually quoted in yen per U.S. dollar. The following table lists the exchange rates for some of the world s major currencies as of July 1, 2011. Identifier Exchange Rate U.S. Dollar per Euro 1.4483 U.S. Dollar per British Pound 1.6046 U.S. Dollar per Swiss Franc 1.1785 U.S. Dollar per Australian Dollar 1.0736 Japanese Yen per U.S. Dollar 80.89 Chinese Yuan Renminbi per U.S. Dollar 6.4649 Prior to August 15, 1971, under the Bretton Woods system, most of the world s currencies were pegged to the U.S. dollar at a fixed rate. The U.S. dollar, in turn, was pegged to gold. This all ended when the U.S. unilaterally terminated convertibility of the dollar to gold, which brought about the current era of floating exchanges rates. Although many currencies are still formally or informally pegged to the U.S. dollar, foreign exchange rates are generally set by market and economic forces for most of the world s major currencies. A Case Study Profiting from a stock that went nowhere Although there are a variety of ways to invest in non-u.s. securities, consider the following hypothetical example involving the stock of a non-u.s. corporation. A U.S. investor becomes interested in a company one we will fictitiously name German Precision Engineering (GPE) whose shares trade on the Frankfurt Stock Exchange. Since GPE is headquartered in Germany, which is a member of the European Monetary Union, GPE reports its financial results in euros and its shares trade in euros on the Frankfurt Exchange. Let s also assume that the current price of GPE is 80 euros per share, and that the U.S. dollar/ euro exchange rate is $1.25 to 1. In other words, it takes $1.25 to purchase 1 euro( ). Let s further assume that the investor wants to invest $10,000 in GPE. Here s how this transaction might look: I nvestor sells $10,000 and purchases 8,000 ($10,000/1.25 = 8,000) Investor purchases 100 shares of GPE for 8,000 ( 8,000/ 80 = 100) One year later, our investor is disappointed that GPE has not appreciated in value and decides to sell his holdings. He receives back 8,000 for the sale of his 100 shares. However, while GPE has not appreciated during that time, the euro has, and the exchange rate now stands at $1.35 to 1. Here s how this transaction might look: Investor sells 100 shares of GPE at 80 per share for 8,000 (100 x 80 = 8,000) Investor sells 8,000 and purchases US dollars ( 8,000 x 1.35 = $10,800) So even though there has been no change in the underlying value of GPE, our investor is now $800 (or 8%) ahead thanks to the appreciation of the euro. Not a bad result for a stock that went nowhere. Proceeds from sale of GPE: $10,800 Initial Investment: (10,000) Profit: $800
Page 3 Forces impacting foreign currency exchange rates A wide range of factors which often interact simultaneously can cause changes in foreign currency exchange rates. U.S. investors, concerned about the future value of the U.S. dollar, typically include: Balance of Trade Deficit: Currently, the U.S. purchases (imports) far more goods and services from overseas than they export. This lessens the need for foreign purchasers of U.S. exports to buy dollars, which would otherwise support the value of the currency. Interest Rates: Funds will generally flow to investments offering the highest risk-adjusted return. With interest rates in the U.S. currently at record lows, there is an incentive for investors to look overseas for better returns. Budget Deficits: Continuing budget deficits, leading to high levels of public debt, damages investors confidence. With approximately $3.5 trillion of U.S. Treasury and Agency securities currently held by foreign governments and institutions (versus $1.7 trillion held by banks in the U.S.), there are signs that foreign holders of dollar-denominated securities are becoming increasingly uncomfortable with this exposure. When the U.S. Dollar weakens How these factors will impact the future value of the dollar is, of course, unknown, but many investors who are concerned about the future depreciation of the dollar and the resultant loss of purchasing power are drawn to non-u.s. investment opportunities as a hedge against this outcome. Obviously, currency movements can work to an investor s advantage. The opposite, however, can also be true in that an adverse movement in the underlying currency can, in effect, neutralize (or worsen) what would otherwise have been a good underlying investment decision were it not for a weakening of the foreign currency in question. Non-U.S. Dollar returns strengthen When the U.S. Dollar strengthens Non-U.S. Dollar returns weaken History may serve as a guide One can see the impact of currency movements on non-dollar equity investments by examining the following chart of selected MSCI international equity indices. Note that the index return expressed in U.S. dollars can be very different than the return in the local currency. The return in local currency is simply the return of the local stock market, compared to the return in U.S. dollars which also captures changes in the exchange rate between the local currency and the dollar. MSCI EAFE MSCI Switzerland MSCI Australia MSCI Canada MSCI Germany MSCI UK MSCI Japan MSCI Returns - Selected Indices -8% -6% -4% -2% 0% 2% 4% 6% 8% 10% 12% USD ($) Local Currency Source: Factset; data year-to-date through June 30, 2011 With this in mind, there is evidence that diversifying internationally into non-u.s. securities would have been beneficial over the past few decades. Consider the following two charts based on data from MSCI. Each examines currency returns of the widely-used MSCI Europe, Australasia, Far East (EAFE) Index. The MSCI EAFE index measures international equity performance outside North America. The chart below shows returns of the EAFE Index in U.S. dollars versus local currency returns for select time periods. Note the wide variance of returns based on the impact of currency movements during certain time periods. Currency Impact on International Investment EAFE (U.S. Dollar) EAFE(Local Currency) Currency Impact Periods of Negative Currency Impact 1981-1984 7.16% 18.81% -11.65% 1999-2001 -4.79% 1.43% -6.22% Periods of Positive Currency Impact 1985-1987 49.29% 21.59% 27.70% 2002-2010 7.18% 2.65% 4.53% Remaining Periods 1988-1998 7.74% 8.11% -0.37% Source: Factset; returns are annualized
Page 4 Although past results are no guarantee of what the future might hold, as evidenced by the chart below, looking at the results of the last 40 years, depreciation of the dollar versus other major currencies has provided approximately 2% excess annualized return to U.S. dollar-based investors in the MSCI EAFE Index. 30% 25% 20% 15% 10% 5% 0% -5% -10% -15% '71 '72 '73 '74 '75 '76 '77 '78 '79 '80 '81 '82 '83 '84 '85 '86 '87 '88 '89 '90 '91 '92 '93 '94 '95 '96 '97 '98 '99 '00 '01 '02 '03 '04 '05 '06 '07 '08 '09 '10 Excess USD Return Source: Factset Since 1971, the depreciating U.S. dollar has provided approximately 2% annualized return advantage for U.S. Investors in the MSCI EAFE Index Red Line indicates 2% annualized return American Depository Receipts (ADRs) Earlier in this paper we used the hypothetical example of an investor who invested directly in the shares of a non-u.s. company on a foreign stock exchange. This is referred to as purchasing ordinary shares, or ORDs. However, most private investors in the U.S. employ another method of investing in foreign shares through the purchase of American Depository Receipts, or ADRs. Unlike ordinary (ORDs) shares, ADRs are purchased and quoted in U.S. dollars. However, perhaps because of this, a common misperception of investors is that, for good or for bad, ADRs are not subject to currency movements. This is untrue. Although a detailed description of the issuance and structure of ADRs is beyond the scope of this paper, ADRs not only track the movement of ordinary shares, but do indeed reflect currency movements, as well. Were this not the case, the value of ordinary shares and the corresponding ADR would drift apart, thus offering an opportunity for professional traders (also called arbitrageurs) to immediately profit from this discrepancy without risk. Ordinary Shares (ORDs) In Non-U.S. Companies Investing in ordinary shares (ORDs) involves acquiring the local currency and buying the company s shares on a local (country) exchange. ORD ownership represents equity in the foreign company and the same voting rights as any international shareholder. ORDs trade on local international markets in local currency terms, yet not every ORD has a corresponding ADR. American Depository Receipts (ADRs) In Non-U.S. Companies ADRs are purchased in U.S. dollars and are depository receipts issued against ordinary shares (ORDs) deposited by the non-u.s. company with a U.S. custodian. Similar to ORDs, ADRs also represent equity ownership. ADRs are not derivatives of ORD, and represent actual equity in the foreign company. ADRs trade on U.S. exchanges in U.S. dollars and every ADR must have a corresponding ORD.
Page 5 Potential Strategies To be clear, not all currency movements are by any means favorable to investors. As illustrated in this paper, the profitability of an investment in an asset denominated in a foreign currency that subsequently depreciates (loses value) against the U.S. dollar can cause the entire transaction to be unprofitable irrespective of the asset s underlying price movement. And investors should keep in mind that the foreign exchange markets can be quite volatile and often move in unpredictable directions. Some recent studies have concluded that over the long term, currency movements have tended to even out. Nevertheless, foreign exchange movements add a new and interesting dimension to investments in non-dollar securities that investors may want to take into consideration. For example, investors who tend to be aggressive with their investments might find that investing in certain non-dollar denominated securities might be appealing given the potential to profit from shortterm currency movements. Other investors, with a longer term investment horizon, who are concerned about the long-term strength of the U.S. dollar, might find investing in non-u.s. securities appealing as a hedge against a decline in the dollar s purchasing power. In addition, some investors may be attracted to non-u.s. securities, but are not inclined to be exposed to currency movements whatsoever. These investors may wish to pursue currency hedging strategies that potentially protect against adverse swings in currency movements while hopefully benefiting from appreciation of the underlying asset. Finally, there is another strategy for international investing that may indirectly offer some of the potential benefits of non-dollar investment. Some investors may be interested in investing in the shares of listed U.S. companies which have significant offshore earnings. As indicated in the table below, these companies represent a significant part of the U.S. equity market and are relatively easy to identify. The S&P 500 generates approximately 33%of its revenues outside the U.S. Likewise, the top 50 companies on the MSCI EAFE index generate nearly 20% of their revenue in America. Sector S&P 500 Sales (Billions $) Total International Foreign Sales Exposure Consumer Discretionary $ 1,203 $ 292 24.3% Consumer Staples $ 3,792 $ 1,463 38.6% Energy $ 1,185 $ 534 45.1% Financials $ 1,378 $ 256 18.6% Health Care $ 1,105 $ 211 19.1% Industrials $ 1,021 $ 355 34.7% Information Technology $ 896 $ 498 55.6% Materials $ 320 $ 148 46.3% Telecom Services $ 284 $ 0 0.1% Utilities $ 335 $ 17 5.1% Total $ 11,518 $ 3,774 32.8%
Page 6 Investing in non- U.S. securities may be appealing as a hedge against declines in the dollar s purchasing power. Conclusion Short-term bouts of volatility in currency exchange rates can significantly impact potential returns and it s important for investors to be aware of and understand currency risks during the portfolio construction process. However, no matter which strategy is most appropriate for an individual investor, we believe that diversifying internationally has the potential to add significant value to an investment program. privateclientreserve.usbank.com IMPORTANT DISCLOSURES Prepared: August, 2011. This information represents the opinion of U.S. Bank and is not intended to be a forecast of future events or guarantee of future results. It is not intended to provide specific advice or to be construed as an offering of securities or recommendation to invest. Not for use as a primary basis of investment decisions. Not to be construed to meet the needs of any particular investor. Not a representation or solicitation or an offer to sell/buy any security. Investors should consult with their investment professional for advice concerning their particular situation. The factual information provided has been obtained from sources believed to be reliable, but is not guaranteed as to accuracy or completeness. U.S. Bank is not responsible for and does not guarantee the products, services or performance of third party providers. Any other organizations mentioned in this publication are not affiliates or associated with U.S. Bank in any way. Past performance is no guarantee of future results. All performance data, while deemed obtained from reliable sources, are not guaranteed for accuracy. Indexes shown are unmanaged and are not available for investment. The MSCI EAFE Index is an unmanaged index that includes approximately 1,000 companies representing the stock markets of 21 countries in Europe, Australasia and the Far East. The country-specific components of the MSCI EAFE Index (Switzerland, Australia, Canada, Germany, United Kingdom, etc.) track publicly traded securities in the country being followed. Equity securities are subject to stock market fluctuations that occur in response to economic and business developments. Investing in fixed income securities are subject to various risks, including changes in interest rates, credit quality, market valuations, liquidity, prepayments, early redemption, corporate events, tax ramifications, and other factors. Investment in debt securities typically decrease in value when interest rates rise. The risk is usually greater for longer term debt securities. Investments in lower rated and non rated securities present a greater risk of loss to principal and interest than higher rated securities. International investing involves special risks, including foreign taxation, currency risks, risks associated with possible difference in financial standards and other risks associated with future political and economic developments. Investing in emerging markets may involve greater risks than investing in more developed countries. In addition, concentration of investments in a single region may result in greater volatility.