Currency Risk: What It Is and Why It Matters for You

You check your portfolio and notice your ETF with US stocks has had a solid few months. But when you look at the actual return in your own currency, it's somehow less impressive than you expected.

No one did anything wrong, the market went up, and yet something quietly affected your return.

Currency movements are one factor that could explain it. Let's break down what's actually going on.

Why Currencies Matter More Than You Think

When you invest in overseas assets, you're not just exposed to what those assets do. You're also exposed to what happens between your home currency and the currency those assets are priced in.

Here's a simple example. Say you're based in Europe and you invest in a US stock ETF. The ETF rises 5% in US dollars.

If, over the same period, the dollar is worth about 4% less in euro terms, your gain in euros ends up being much smaller than you'd expect.

In some cases, a currency move can wipe out what looked like a solid return in the foreign market.

The reverse is also true: if the dollar becomes more valuable relative to the euro, your US investments can look even better when converted back.

Currency can quietly work in your favour, or against you, without anything changing in the underlying market.

What Actually Moves Exchange Rates?

Exchange rates shift for a few key reasons. Differences in interest rates are one of the biggest drivers: when a central bank raises rates, its currency often tends to strengthen as investors move money there for better returns.

Inflation plays a role too, since a currency tends to weaken over time if a country's inflation runs consistently higher than others'.

Economic growth expectations matter as well. When investors feel confident about a particular economy, they tend to buy assets there, which means buying that currency first.

And during periods of global stress, money often moves into currencies seen as safe havens, like the US dollar or Swiss franc, regardless of what's happening in those specific economies.

When a central bank raises rates, its currency often tends to strengthen as investors move money there for better returns.

On top of these “natural” market forces, central banks and governments can sometimes step in and actively buy or sell currencies in the foreign exchange market to influence their value, a practice known as currency intervention.

Major central bank decisions and geopolitical events can move exchange rates sharply and quickly, which is part of what makes them difficult to predict in the short term.

How Currency Risk Shows Up In Your Portfolio

When a European investor buys a US S&P 500 ETF, she's taking on two separate things at once: market risk (what US stocks do) and currency risk (what the dollar does relative to the euro). Both affect her final return.

It's also worth knowing that even a "global" fund listed on a European exchange can carry significant currency exposure inside it, if it holds US, Japanese, or emerging market assets priced in foreign currencies.

The fund being listed in euros doesn't mean its underlying assets are in euros.

The same idea applies when you see an S&P 500 ETF trading in EUR or GBP: you still have US dollar exposure, because the companies in the index are priced and traded in dollars.

Buying an individual US stock like Apple on a German exchange also leaves you with US dollar risk, because what ultimately matters is the currency of the company’s primary listing and the market where its shares actually trade.

What ultimately matters is the currency of the company’s primary listing and the market where its shares actually trade.

This is where hedged and unhedged funds come in. An unhedged fund means you take the currency swings as they come. A hedged fund tries to cancel out those swings, so your return is closer to what the underlying assets actually did, regardless of what currencies did in the meantime.

Hedging isn't perfect and usually comes at a small cost, but it does make your returns more predictable from a currency perspective.

Is Currency Risk a Problem?

Not necessarily. Over the long term, holding assets in different currencies can actually be a form of diversification, since different economies and currencies move at different times and different speeds.

Over shorter periods, though, currency moves can be disorienting. A fund might fall in value not because anything went wrong with the underlying companies, but simply because exchange rates shifted. That's useful to understand so it doesn't catch you off guard.

It's also worth thinking about what currency your future spending will be in. If your life is in euros or pounds, that's a reasonable lens for thinking about whether your portfolio's currency exposure makes sense for your situation.

Key Takeaways

Some currency risk is a completely normal part of global investing. The goal isn't to eliminate it, it's to understand it. A few questions worth sitting with: Do you know whether your main funds are hedged or unhedged? And does your overall currency exposure feel roughly aligned with your life and your long-term goals?

You don't need a perfect answer. But knowing what you're exposed to, and why, puts you in a much stronger position than most.

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