We’ve seen countless investors celebrate strong returns from their international holdings, only to discover later that currency movements were the real driver—not the underlying investments. Similarly, we’ve watched excellent international stock picks get crushed by unfavorable exchange rate moves. Understanding how currencies affect investment performance isn’t just an academic exercise—it’s a practical necessity for anyone with international exposure.
The Hidden Performance Driver Most Investors Ignore
Currency effects are one of the most overlooked factors in investment performance analysis. When you check your portfolio and see that your European stock fund is up 12% this year, that number combines two distinct components: the actual performance of European stocks in euros, and the movement of the euro versus your home currency.
This distinction matters more than most investors realize. In some years, currency moves contribute more to your returns than the underlying investment performance.
Real-World Currency Impact on Returns
Let’s look at a concrete example. In 2022, European stocks (measured by the Euro Stoxx 50) gained 6.7% in euro terms. Sounds decent, right? But for U.S. investors, the euro fell nearly 10% against the dollar that year. The result? U.S. investors actually lost money on their European stock holdings despite the positive local returns.
Conversely, in 2017, European stocks gained 10% in euros, but the euro strengthened 14% against the dollar. U.S. investors saw returns over 25%—more than double the local market performance.
These aren’t isolated cases. Currency swings of 5-15% annually are common between major currencies, meaning your international investment returns can easily fluctuate by this much regardless of how the actual companies perform.
The S&P 500 Through Different Currency Lenses
Here’s a fascinating example that really drives the point home. The S&P 500 is a U.S. index priced in dollars, but investors around the world buy it in their local currencies. Let’s compare how the same investment performed for two different investors during 2023:
U.S. Investor (investing in USD):
- January 2023: Invests $10,000 in S&P 500 at 3,824 points
- December 2023: S&P 500 closes at 4,770 points
- Return: +24.7%
- Ending value: $12,470
European Investor (investing in EUR):
- January 2023: Invests €10,000 (equivalent to $10,680 at EUR/USD 1.068)
- Buys S&P 500 exposure
- December 2023: S&P 500 gains 24.7%, but EUR strengthens to 1.105 against USD
- The stronger euro means each dollar of S&P 500 gains is worth fewer euros
- Actual return in EUR terms: +21.3%
- Ending value: €12,130
Same index, same time period, but the European investor’s return was 3.4 percentage points lower simply due to currency movements. The euro strengthening from 1.068 to 1.105 meant that when converting those dollar-denominated S&P 500 gains back to euros, they received less.
Now imagine the opposite scenario in 2022, when the euro weakened from about 1.137 to 1.071 against the dollar. A European investor would have seen their S&P 500 losses cushioned by the weakening euro, while their actual investment was down.
This demonstrates that even when you’re investing in domestic indices of other countries, your returns will differ based on your home currency. It’s not just about picking the right market—the exchange rate matters just as much for your actual returns.
How Currency Effects Work in Your Portfolio
When you invest internationally, you’re making two simultaneous bets whether you realize it or not:
First, you’re betting on the performance of the underlying asset—whether that’s stocks, bonds, or real estate. Second, you’re betting on the exchange rate between your home currency and the foreign currency.
If you’re a U.S. investor buying Japanese stocks, you convert dollars to yen, buy the stocks, and eventually convert the proceeds back to dollars. Any change in the USD/JPY exchange rate during this time affects your returns.
The Math Behind Currency Impact
Here’s the formula that governs your total return from international investments:
Total Return = (1 + Local Return) × (1 + Currency Return) - 1
So if Japanese stocks gain 8% in yen terms and the yen strengthens 5% against the dollar, your total return is approximately 13% (not 13% exactly due to the compounding effect, but close).
If those same Japanese stocks gain 8% but the yen weakens 5%, your return drops to around 3%.
Measuring Currency Impact in Your Portfolio
Most investment platforms show you the total return on your international holdings but don’t break down the currency component. This makes it difficult to understand what’s actually driving your performance.
Calculating Currency Contribution
To isolate the currency effect, you need to compare:
- Local returns: How much the investment gained in its home currency
- Total returns: How much you gained in your home currency
- Currency impact: The difference between these two figures
Many fund companies publish both hedged and unhedged versions of the same fund. Comparing their performance can give you a clear picture of how much currency movements are helping or hurting returns.
Tracking Your Currency Exposure
Calculate what percentage of your portfolio has currency exposure:
- U.S. stocks: Generally minimal currency exposure (though large multinationals have operational currency exposure)
- International developed market stocks: Full currency exposure to euros, yen, pounds, etc.
- Emerging market stocks: High currency exposure to more volatile currencies
- International bonds: Often substantial currency exposure
- Currency-hedged funds: Minimal currency exposure
Understanding this breakdown helps you know how sensitive your overall returns are to currency movements.
When Currency Effects Help Performance
Currency movements aren’t always a problem. In fact, they’ve boosted returns for many investors over extended periods.
Dollar Weakness Benefits International Investors
When the dollar weakens, U.S. investors holding international assets benefit. Your foreign investments become worth more when converted back to dollars.
From 2002 to 2007, the dollar weakened significantly against most major currencies. During this period, currency effects added substantially to U.S. investors’ international returns, turning good foreign market performance into spectacular returns.
Currency Diversification Benefits
Holding assets in multiple currencies can protect you from any single currency losing significant value. This is particularly valuable during periods of domestic economic stress or inflation.
If your home currency is weakening due to inflation, your international holdings may maintain their purchasing power better than purely domestic investments.
When Currency Effects Hurt Performance
Of course, currency movements can just as easily work against you.
Dollar Strength Reduces International Returns
When the dollar strengthens, U.S. investors see reduced returns from international holdings. Strong foreign market gains can be partially or completely offset by currency headwinds.
The 2022 example we mentioned earlier is a perfect illustration—strong dollar performance turned positive European stock returns into losses for U.S. investors.
Emerging Market Currency Crises
Emerging market investments can suffer dramatic losses during currency crises. The 1997 Asian Financial Crisis, the 2001 Argentine peso collapse, and more recent Turkish lira crashes have devastated investors who didn’t account for currency risk.
These events remind us that while currency effects can be positive over time, they introduce genuine risks that can’t be ignored.
What You Can Do About Currency Risk
Understanding how currencies affect your returns is the first step. The next question is what, if anything, to do about it.
Accept the Exposure
Many long-term investors simply accept currency risk as part of international investing. Over decades, currency movements tend to be less directional, and the diversification benefits often outweigh the short-term volatility.
If you have a long time horizon and can tolerate additional volatility, accepting currency exposure requires no extra effort or cost.
Use Hedged Funds
Currency-hedged funds use financial derivatives to neutralize most currency exposure. These funds track the underlying foreign market returns without the currency component.
The advantage is reduced volatility and returns that more closely reflect the actual performance of foreign companies. The disadvantage is higher fees (typically 0.1-0.3% extra) and missing potential gains from favorable currency moves.
Partial Hedging Strategies
Some investors hedge a portion of their currency exposure while leaving the rest unhedged. This approach balances the volatility reduction from hedging with the diversification benefits and cost savings from unhedged exposure.
For example, you might hedge 50% of your developed market international exposure while leaving emerging market exposure unhedged.
Dynamic Currency Management
More sophisticated investors adjust their currency exposure based on market conditions, hedging more when their home currency appears undervalued and less when it appears overvalued.
However, consistently predicting currency movements is notoriously difficult, even for professional currency traders. This approach requires significant research and carries the risk of mistimed decisions.
Currency Impact Over Different Time Horizons
The significance of currency effects varies dramatically depending on your investment timeline.
Short-Term (1-3 Years)
Currency movements can dominate short-term performance. Over 1-3 year periods, currency effects often exceed the returns from the underlying investments.
If you need to access your international investments in the near term, currency volatility presents genuine risk that might warrant hedging.
Medium-Term (3-10 Years)
Over 3-10 year periods, currency effects remain significant but tend to partially offset each other as currencies rise and fall through different economic cycles.
Investment performance becomes more balanced between the underlying assets and currency movements.
Long-Term (10+ Years)
Over decades, currency movements tend to mean-revert somewhat, though not completely. The performance of the underlying investments typically becomes the dominant factor in your returns.
Long-term investors can often afford to accept currency risk as the time diversification reduces the risk of being permanently hurt by unfavorable currency trends.
The Role of Currency in Performance Analysis
When evaluating your investment performance or comparing investments, it’s crucial to understand the currency component.
Comparing Fund Performance
If you’re choosing between two international funds and one has significantly outperformed the other, ask whether the outperformance came from better stock selection or currency effects.
A fund might show great returns simply because it had higher exposure to currencies that strengthened, not because it picked better companies.
Evaluating Your Investment Decisions
When reviewing your past investment choices, separate the investment decision from the currency outcome. You might have made an excellent investment choice that was undermined by currency moves, or a poor investment choice that was bailed out by favorable exchange rates.
This distinction helps you learn the right lessons from your experience.
Practical Tips for Managing Currency Impact
- Know your exposure: Regularly calculate what percentage of your portfolio has currency risk
- Track currency contribution: When possible, separate local returns from currency effects
- Consider your timeline: Longer horizons generally mean less need for currency hedging
- Factor in costs: Hedging isn’t free—make sure the benefits justify the expense
- Don’t try to time currencies: Consistent currency prediction is extremely difficult
- Review periodically: Currency exposure changes as your portfolio grows and market values shift
When to Seek Professional Guidance
Currency risk management can get complex, especially if you have:
- Substantial international holdings across multiple currencies
- Shorter investment timelines where currency volatility presents greater risk
- Specific currency views you want to implement
- International real estate or business interests
In these cases, professional guidance can help you develop a currency strategy that aligns with your overall investment objectives.
Currency effects are a permanent feature of international investing, not a bug to be eliminated. Understanding how exchange rates impact your investment performance helps you make informed decisions about how much international exposure to hold, whether to use hedged or unhedged funds, and how to interpret your returns.
Rather than viewing currency fluctuations as purely negative, consider them another dimension of diversification that can help protect your wealth over time, even if they add short-term volatility.
Managing currency exposure and understanding its impact on your returns requires careful tracking and analysis. These calculations can be tricky, especially across multiple accounts and asset types. Tools like OnePortfolio can help by providing visibility into how currency movements are affecting your overall investment performance.
Want to understand how currency fluctuations are affecting your international investments? Try OnePortfolio Free to track your portfolio’s currency exposure and its impact on your returns.
