Expat Financial Advice: Practical Currency Management for Expat Portfolios
By Chad Creveling, CFA, & Peggy Creveling, CFA
One of the more confusing issues for many expats residing overseas is managing their currency exposure. If you're an American working in Vietnam and plan to retire in Thailand, should you be investing in the U.S. dollar (USD), the Vietnamese dong (VND), or the Thai baht (THB), or does it matter? Compounding the problem, many expats don't know what their actual currency exposure really is. Is it the currency stated on your brokerage statement, the currency your investments are reported in, or something else?
Back in your home country, it's all pretty straightforward. You're paid in your home currency, you pay your bills in your home currency, and most of your investments are likely in your home currency. In this case, you generally have very little currency risk. The problem for expats is that they have too many choices. They have their home currency, the currency where they live and work, and the currency of their future expenses, whether those include retirement, a vacation home, or their kid's college education. Throw in a Japanese yen mortgage to fund a British property and a dual-currency product on the Australian dollar and you have some real confusion.
Without a suitable framework to think about and implement a practical currency exposure, expat investors can unwittingly expose themselves to significant currency risk, which can wreak havoc with their finances and their financial goals.
What Currency Risk Is and Why It Matters
For expats, currency risk is primarily the impact of large currency swings on their family assets and liabilities that are denominated in different currencies. For example, if you plan to retire in Thailand, but the underlying currency exposure of the portfolio intended to fund your retirement is primarily in USD, any significant strengthening of the THB against the USD is going to cause problems.
Likewise, if you intend to buy property in Spain and fund it with a Japanese yen (JPY) loan and you're paying off the loan using USD, you have significant currency exposure. If the JPY strengthens against the USD, you may have a hard time paying off the mortgage. If the JPY strengthens against the euro (EUR) as well, you may find that the value of your property is worth a lot less after paying off the now more expensive mortgage.
When investing, it's important to understand that in most cases you are investing in not only an asset, but also a currency. If you invest in a property in Spain, you are investing in the physical asset, but also the euro. If you are a euro-based investor, then the currency exposure doesn't matter, but if you're a USD-based investor, it does.
When investing in European stocks, you are investing in not only the future earnings of European companies, but also the currencies in which those earnings are derived. If those earnings are primarily in EUR and you are a USD investor, exchange rate movements of the euro against the USD will add to or detract from your investment returns.
In general, any mismatch between the underlying currency of your investments or assets and your base currency, or the currency you will need those assets to fund, carries the potential for adverse outcomes. This is currency risk.
What Is Your Base Currency?
For an expat, it can sometimes be difficult to determine base currency. Is it your home country currency? The currency of your country of residence?
Well, it depends. If you're a Canadian temporarily working overseas with the intention to retire in Canada, buy a home in Canada, and send your kids to school in Canada, then the Canadian dollar is clearly your base currency.
If you're an American who intends to permanently retire in Thailand, then your base currency may be the THB. The currency denomination of the future liability you intend to fund—whether it is retirement, a home purchase, or college funding—should largely determine your base currency and the primary currency exposure of your assets.
Your True Currency Exposure
To avoid significant currency risk, it's important to understand your true currency exposure. If you invest in a house in Spain, it's pretty clear your currency exposure is the euro, but it's not as easy to determine for your investment portfolio. It's not necessarily the currency on your brokerage statements or the currency your investment is traded in.
If you are investing in Eurozone companies that are listed on the Swiss exchange in Swiss francs (CHF) and your bank statement lists the value of the investment in USD, it gets a little confusing. Your true currency exposure is the currency in which the Eurozone companies' earnings are derived. In this case, it's probably the euro. It doesn't matter that the stock is listed and traded in Swiss francs. The same stock could be listed in USD on the New York Stock Exchange or the British pound (GBP) on the London Stock Exchange. The currency of listing is merely a convention of convenience. Regardless of where the stock is listed or traded, the underlying economic exposure is to the euro. The value of the companies’ stock would be the same in every case, just expressed in different currencies at current exchange rates.
The currency of the brokerage statement is equally misleading. If you invest with a U.S. custodian, the statement will use the USD. If you invest with a Thai broker, the statement will most likely be in THB. Some custodians will segregate investments by the currency of listing, but as discussed above, this is not necessarily your true currency exposure. Again, the reporting currency is merely a convenience determined primarily by where your account is held.
In constructing your investment portfolio, as well as in managing your overall financial situation as an expat, it is important to understand the currency that your future goals are denominated in and build an appropriate underlying currency exposure into your investment and financial plan.
A Practical Framework for Managing Currency Risk
Fortunately, managing your currency risk doesn't require exotic hedging tools such as currency forwards, futures, options or currency swaps, or even the services of a Swiss bank.
By following a few simple principles, you can eliminate much of the currency risk from your finances and avoid jeopardizing your financial goals.
- Determine your base currency or reference currency for each of your major financial goals. For example, if you plan to purchase a house in Canada, your base currency for this goal is the Canadian dollar (CAD).
- Match the currency exposure of the assets intended to fund each of your goals with the goal's base currency. If you intend to send your kids to college in the U.S., ensure the investments intended to fund those college expenses are largely USD investments.
- Make sure you understand your true currency exposure. Don't assume it's the currency on your brokerage statement or the currency the investment is traded in. You may need to do a bit of research, particularly if you invest in multinational companies, mutual funds, or exchange-traded funds (ETFs).
- Consider using different portfolios to fund goals with different currencies. If you intend to retire in Asia, buy a home in Europe, and send your kids to school in the U.S., you may want to fund these goals with three distinct investment pools that would allow you to match the currency exposure of the investment assets with currency of the expenses they intend to fund.
- Fixed income investing: For each portfolio, it's most important to hedge the cash and fixed income portion since currency movements can have a big impact on the long-run returns of these types of investments. A bit of currency diversification here is OK, but most of the exposure should be matched to the future expense.
- Equity investing: Currency volatility does not have as great an impact on the long-run returns of the equity (stock) portion of the portfolio. Generally, it's best to maintain diversification across most equity asset classes, industries, and geographical regions with perhaps a slight bias to the future currency liability.
- Where possible, use ETFs and mutual funds that are internally hedged to your desired currency exposure. For example, for a USD goal you probably want to use USD bonds rather than EUR bonds. Or you could use an emerging market bond fund hedged back to the USD rather than an unhedged emerging market bond fund. With the rapid proliferation of ETFs, this is getting easier to do for many currencies.
- What if you don't know what currency your future liabilities will be denominated in? For example, you're not sure where you will retire or where your child will attend university. In this case, you should try to narrow down the possible choices and then build a portfolio that is diversified across those choices. This preserves your flexibility without making a large bet on one particular currency region. Once you've made a final decision, you can rework the portfolio.
A Word on Currency Speculation: It's a Zero-Sum Game
Most expat investors should regard currency management more as a way to reduce risk than a way to increase returns. Unlike stocks, bonds, and other investments, currencies are a zero-sum game. If one currency appreciates, the other must depreciate. There is no long-run return potential as with stocks, bonds, and other investments. After all, one country's currency cannot appreciate against another's indefinitely.
Furthermore, currencies are affected by a complex interplay of economics, politics, and other random variables, which makes them notoriously difficult to predict even for professional currency traders. Taking bets on currency is little more than gambling, where you can be expected to lose more than half the time after accounting for expenses. Sometimes, you can get lucky in the short run, but over the long run, the risk and cost of getting it wrong greatly outweigh the potential benefits for most expats.
To avoid jeopardizing your future financial goals, take the time to understand your currency exposure and take steps to eliminate unnecessary currency risk from your finances.
Note: This is an updated version of an article that we originally published on August 7, 2012.