Currency risk when you invest across the Atlantic

If you live in the eurozone and buy a US equity ETF, you have made two bets, not one. The first is that American companies will earn more. The second is that the dollar will not weaken against the euro while you hold them. Only the first bet gets discussed in the product brochure.

Currency risk is the part of a foreign investment's return that has nothing to do with the asset. A US index can rise 7% in dollars and leave a euro investor with less money than he started with. That is not a market failure or a fee problem. It is the exchange rate doing exactly what exchange rates do — and it is the one risk in the portfolio that shows up as a currency rather than as a company.

The same fund, three different outcomes

Take $10,000 invested in a US equity index fund, earning exactly 7% a year in dollars for three years. In dollars, the position grows to $12,250. That part is arithmetic and it does not change.

What changes is what those dollars are worth when you convert them back. At 1.05 dollars per euro — roughly where the pair sat in autumn 2022 — the position starts at €9,524. Three years later, with the dollar amount up 22.5%, the euro value depends entirely on the rate.

Read the top line again. The fund gained 22.5% in its own currency and the euro investor lost 14% of the original stake. Nobody made a bad stock pick and no fee explains it.

What the currency did to a good year

The mechanics are easier to see in one year's numbers. Hold that same position through a year in which the US market returns a solid 7% and the euro strengthens from 1.05 to 1.15.

In dollars the position gains $700. In euros, the currency move costs more than the gain. Here is the arithmetic laid out as a waterfall:

A 1.05 to 1.15 move is under 10% — an ordinary year for this currency pair. It was enough to turn a perfectly good equity return into a loss for a eurozone investor. The same move in the other direction does the reverse: had the euro weakened to 0.95, the dollar gain would have been joined by a currency gain and the year would have looked excellent. Currency is symmetric. It just is not neutral.

It is also close to unpredictable. Major banks employ teams of economists to forecast this pair, and their one-year forecasts miss by wider margins than the annual move itself. That matters for what you do with the information: the point of measuring currency risk is to size it honestly, not to form a view on which way the euro is heading.

Why this is not a reason to avoid US assets

The wrong conclusion is to sell everything foreign. Half the world's equity value sits in US companies, and a portfolio without them is making an active bet against the largest, most profitable firms on the planet. The right conclusion is narrower: know what you own, and decide deliberately how much currency exposure you want.

There is also a real argument that currency risk partly cancels out over long periods. A German company selling machines in dollars benefits when the dollar is strong and complains when it is weak. If you hold a globally diversified index fund, you own both the exporters and the importers, and their currency exposures offset inside the fund. That effect is real, and it is slower and messier than the sales pitch suggests. What does not cancel out is the timing. Your contributions arrive at whatever rate the month offers, and the rate you convert at on the day you retire is the one that sets the outcome.

There is one thing the offset does not cover, and it is the reason the effect is weaker than it sounds. The companies in the index hedge their own currency exposure, borrow in several currencies, and price in whatever currency the customer prefers. The net exposure that reaches a fund's shares is smaller than the headline revenue split implies — which cuts both ways. The protection is real, and so is the fact that the remaining exposure is concentrated in exactly the periods when it hurts.

What does not cancel out is volatility. Unhedged currency exposure adds somewhere in the region of 8 percentage points of annual volatility to a foreign equity holding — roughly doubling the swing you would otherwise see, because the exchange rate moves a lot and moves independently of the shares.