6 ways to hedge currency risk in foreign equity | Economic Times

1,000% return in just 10 years. No, we are not talking about a penny stock or worse, not a Ponzi scheme. This is the kind of returns earned by those investors who invested in the stocks of American mega corporates like Apple, Microsoft, Tesla, and Amazon 10 years ago. That is right, if you had invested Rs 1 lakh in any of these multi-baggers back in 2011, your investment would be worth more than Rs 10 crore today. And now, despite being a pandemic year, the US stock markets closed at record highs in 2020. This has piqued the interest of many Indian investors who are either taking the direct equity route or are using mutual funds to invest in not just the US market but other global markets as well. Many Indian fund houses have even launched mutual fund schemes to cater to this demand. While many of these stocks have returned handsome gains and global equities are a good way to diversify, but before jumping on the bandwagon and putting in the money to invest, one should also be mindful of the risks. That is because, along with the usual risks associated with equities, international equities also come with the risk of currency exchange rate fluctuations. This could be a double whammy if your selected stock or MF underperforms and there is also an adverse currency movement, particularly when you are planning to exit. We tell you why you need to factor in exchange rate while investing in global equities and what you can do to safeguard your investment against any adverse currency movements.The risk of exchange rateWhile investors are not wrong in expecting above average returns from international equities, but if the exchange rate movement is not favorable, specifically for one's time horizon, then it could significantly squeeze the net return. "When investing internationally, exchange rate risk is an additional risk that one is taking. Since the investments made are in dollars, there is a currency conversion that needs to be done when depositing and withdrawing funds in Indian rupee and hence, the exchange rate at that point affects the returns," says Viram Shah, Co-Founder and CEO, Vested Finance, a US Securities and Exchange Commission registered investment adviser. 82984874USD/INR data from August 28, 2013 to May 25, 2021, Source: RBI, FBIL and GeojitIndia being a developing country has largely seen one way movement of the exchange rate where it has been depreciating against the US dollar over the past 8 years. However, during this period, there have been many instances where the rupee did appreciate strongly in value."Although Indian rupee is expected to continue depreciating against the US dollar due to the interest rate differential between the countries, it is possible for it to appreciate due to other macroeconomic factors. If USDINR depreciates more than the dollar-based return of the underlying investment, the net return can be negative," says Prateek Jain, Co-founder, Winvesta, a global investment platform for Indian investors. Return adversely impacted by exchange rate movement Stock Buy Price (18 May 2020) Sell Price (25 May 2021) Absolute Equity Return Exchange Rate Net return Apple 78.74 126.9 61.16% -4.06% 54.62% Amazon 2,426.26 3,259.05 34.32% -4.06% 28.87% Walmart 127.66 142.34 11.50% -4.06% 6.97% Viatris 16.46 14.98 -8.99% -4.06% -12.69% MarketAxess Holdings 492.66 458.52 -6.93% -4.06% -10.71% Vertex Pharmaceuticals 284.13 208.76 -26.53% -4.06% -29.51% Source: S&P 500 stocks data from Yahoo Finance, exchange rate - FBIL and GeojitThe critical role of currency in international equityTo invest in US stocks you need to open a brokerage account in the US. "When you buy stocks in the US markets from India, you are required to open a US brokerage account and wire funds to the US via RBI's Liberalised Remittance Scheme. This is facilitated by a few investment platforms in India," says Harsh Jain, Co-founder and COO, Groww, an online investment platform.Once you transfer your Indian currency into the US brokerage account it is converted into US dollars at the prevailing exchange rate, and then you can buy or sell stocks in dollars. While exiting you sell stocks in dollars and withdraw money which is converted back into Indian rupee at the prevailing exchange rate. Though it involves certain amount of conversion charges also, but the factor that has maximum impact on your return is the exchange rate difference between buying and selling. In case of India based MFs, the currency aspect is managed by the AMC, nevertheless the exchange rate will have an impact on the returns. Here are six ways you can reduce the impact of adverse currency movements on your returns.Investing for the long termVolatility is higher in the short term for the price of equity and currency rate, both of which reduces if the investment period is longer. "If a stock is doing well and giving more than a 10% return on a yearly basis, even if the INR gains against the dollar, the impact on returns is typically quite small compared to the returns that the stock would have provided," says Shah.India being a developing country with high inflation has witnessed overall depreciation of its currency in the longer periods which is unlikely to change in significant future. "Given that we have higher inflation in India vs. the US and since we are net importers, the rupee tends to depreciate over time. Thus, in the long-run having dollar exposure in your portfolio actually helps add to the returns," says Shah. 82796988As on 30 March 2021, Source: Stockal IncAs your investment horizon increases, the chances of the currency movement working in your favour is higher. "In the last decade, for example, the US dollar appreciated against the Indian rupee by 4-6% annually. On an average US stocks performed 4.4% better than Indian stocks between 2010-2019. However, once you add dollar appreciation to it, the outperformance was over 11% annually," says Jain. If your time horizon is long and your equity investment is performing well, the impact of minor adverse change in currency will not be much. "Exchange rate usually does not change more than 3-5% in a year, and the rupee has barely become cheaper in any year in the last 10 years. So more often than not, if a stock does well, the investment would have further gains with the dollar rising as well," says Sitashwa Srivastava, Co-founder & Co-CEO, Stockal Inc a digital global investment platform.Using country diversificationIf you invest in one country the currency risk is likely to be higher, so diversifying your investments into different countries can help in reducing this risk. "Diversifying your portfolio across geographies not only protects your investments against the country-specific investment risks, but also against single currency risk," says Jain of Winvesta.You can take the mutual fund route to find the right country diversification. "There are quite a few mutual funds in India that allow investors the opportunity to invest in international markets outside the US. It can work as a natural hedge against exchange rate fluctuations," says Jain of Groww."Apart from international funds that invest in US stocks, there are some others which invest in markets like China, Japan, Brazil, etc. Their currencies have seen higher fluctuation against the rupee and hence, it might be difficult to take a stand. Investing in US equities, on the other hand, gives enough diversification which diminishes the marginal diversification gains from investing in other markets for most investors," says Prateek Mehta, Co-Founder and CBO, Scripbox."You can also invest in other countries through US-listed ETFs that provide exposure to those countries. EWJ and EWZ ETFs, for example, give exposure to Japan and Brazil respectively," says Jain of Winvesta.Taking limited exposure For many investors who have only limited exposure to international stocks, country diversification may not be of much help. "Since the majority of your portfolios are denominated in Indian rupee, investing in US dollars also provides the much-needed currency diversification to your portfolio so that rupee depreciation and inflation don't eat away at your returns," says Shah.There are many experts who feel that when investing in developed countries the currency risk is not significant. "Most overseas investments tend to be in mature capital markets like the US, UK, Germany et al. Generally, when the rupee falls against the dollar, it also falls relative to the British pound and the euro," says Srivastava.Further, many renowned international stocks like Ali Baba, LG Display, Toyota Motors, Nomura Holdings, AstraZeneca and Yandex listed in the US, so investing in US market itself gives good country diversification.There is a short-term risk of adverse currency fluctuations, says Mehta, which gets balanced by the rest of your portfolio which is invested in Indian companies. Timing the investmentIf you are savvy investor and understand the nuances of currency movement then you may use this to your advantage. "People on the Stockal platform sometimes wait for USD to become cheaper before they fund their investing accounts. It matters less for short-term investors because exchange rate doesn't change that often but for medium-to-long-term investors, the exchange rate has a significant impact on their performance," says Srivastava.Use of derivativesThere are hedging options which can work well to reduce the currency risk, however, derivatives comes with their own set of risks. "One must remember that derivatives carry their own risk and also that Indian retail investors, making overseas investments via the LRS route are not allowed take leverage or invest in leveraged products (which is the case with almost all derivatives)," says Srivastava.Layman investors who do not understand the intricacies of derivatives will be better off steering clear of this route. Savvy investors, in absence of direct hedging options, can use indirect options such investing in currency ETFs like FXB and FXE that track other major currencies says Jain of Winvesta.If you have invested in international stocks through MFs then you can find many options where the currency risk will be taken care by the fund manager by using derivatives. "Some international funds eliminate the exchange rate risk by including currency forward contracts in the fund's portfolio. These contracts allow the fund manager to lock an exchange rate at a future date and reduce the impact of adverse rate movements. Investors can also look at buying units of currency hedge funds to further mitigate this risk," says Jain of Groww.Forex related end useIf you are an investor who may need foreign currency in future, you may do well to keep a part of your portfolio in international equities. "For most people, roughly 10-15% exposure to international funds/ equity is sufficient for requirements that might emerge in foreign exchanges," says Mehta.The best thing you can do with your foreign exchange denominated invested is to utilise it for your own foreign currency needs. "If you have international expenses coming up such as education and travel, spending the USD that you have invested mitigates the currency risk since you don't have to convert the funds back to INR," says Shah. This will not only save your expenses from exchange rate risk but also from conversion charges.