While allocating to markets other than an investor’s home country can provide diversification benefits, it also introduces currency risk, with foreign exchange rate volatility potentially having a significant impact on overall returns.

From an Australian investor’s perspective, when the A$ strengthens against the foreign currency in which the underlying asset is denominated, then the return on the investment will be lower when measured in A$’s. Conversely, if the A$ depreciates, then the return on an asset denominated in a foreign currency will increase in Australian dollar terms, i.e. currency movements can have both positive and negative impacts on local currency returns.

To illustrate, consider an investment in the US S&P 500 Index between two periods that experienced substantial exchange rate movements. Firstly, between 27/10/08 and 27/7/11, during which period the A$ appreciated from a GFC low of 60 cents to the commodities boom high of 110 cents. The second being between 27/7/11 and 19/07/16, during which period the A$ depreciated from its record high to 75 cents against the US$. The stark difference in returns on the underlying asset (in US$) and the overall return for an unhedged domestic investor (in A$) is reflected below:

Period Return (US$)Return (A$)
27/10/08 - 27/07/1163.4% -9.2%
27/07/11 - 19/07/1684.7% 171.2%

For investors looking for portfolio diversification by allocating internationally, it is important to consider not only the attractiveness of the underlying asset, but also the potential currency risk.

If you would like more information, please call 1300 ELSTON or email info@elston.com.au and an adviser will be in touch.

*This article is for information purposes only and does not constitute financial advice.