How Does a Strong Dollar Affect International Mutual Funds?

A strong dollar is not a positive event for international mutual fund investors.

International mutual funds give investors exposure to stock and bond markets outside the United States. Investing in international funds provides asset diversification and the possibility for yield or gains significantly greater than in the U.S. markets. The conversion of stock and bond prices from the currency of home country of the investments to the U.S. dollar can have an effect on the return earned in the U.S.

Converting Currencies

Change currency exchange rates affects the value of stocks and bonds when converting from one currency to another. A weak currency makes items in the other currency more expensive when converted to the first currency. This is a positive in respect to stocks or bonds. The foreign investments become more valuable in dollar terms. A strong dollar has the opposite effect. As the dollar strengthens against a foreign currency, the items priced in the other currency will lose value when converted to dollars.

Strong Currency Example

As of the beginning of 2011, the U.S. dollar has been weak against most of the world currencies. An example showing the effect or a weak dollar can be reversed to indicate the effects of a strong dollar. In 2009, the Brazilian stock market -- BOVESPA -- gained 69.7 percent in terms of the Brazilian currency -- the Real. When the results are converted to the dollar, which weakened over 2009, U.S. investors saw a total return from the Brazilian stock market of 126 percent. The portion of the gain to U.S. investors due to a weak dollar was over 50 percent. If the trend between the dollar and Real reversed, U.S. investors could see their investments drop in dollar terms, even if the Brazilian stock market shows gains.

Currency Effects on Mutual Funds

A strong U.S. dollar could have a significant negative effect on the results earned by international stock or bond funds. The example shown above was due to an extreme value change in the Brazilian Real. A February 2011 article in Smart Money magazine notes that there is low correlation between the returns of foreign stock markets in local currency and the exchange rate between the local currency and the U.S. dollar. This means if your international stock fund buys foreign stocks that perform very well, the effects of a strong dollar will be mitigated.

Hedging Currency Risks

International mutual funds do have the option of hedging currency risks. Hedging involves buying futures or other instruments that will negate or reduce the effects of a strong dollar on the value of securities designated in foreign currencies. To determine if a specific international mutual fund uses hedging strategies, read the fund manager comments the press releases concerning fund performance. If you cannot find any information concerning a fund's hedging philosophy, call the fund or your financial advisor and ask for the information.

References

• Learning Markets: How Currency Risk Affects You
• Smart Money: How to Protect Yourself Against Currency Risk, 2-11-11
• World Federation of Exchanges: WFE Database