Lazy Portfolios: The Risk of Currency Exchange
Lazy portfolios are a popular investment strategy, known for their simplicity, low cost, and diversification benefits. These portfolios are designed to require minimal effort from the investor, typically consisting of a few broad-based index funds that are rebalanced periodically. The concept behind lazy portfolios is to take a set-it-and-forget-it approach, where investors can stay invested in the market without needing to make frequent decisions or trade actively.
While lazy portfolios have many advantages, such as ease of management and cost-efficiency, they also come with their own set of risks. One of the most overlooked yet crucial risks is the currency exchange risk, which can significantly impact both the returns and the volatility of a portfolio, especially when dealing with global investments.
The Volatility of Lazy Portfolios: A Deeper Dive
The volatility in lazy portfolios can typically be attributed to two main factors:
1. The Type of Underlying Assets: The more equity-based the portfolio, the higher its volatility. Stocks generally experience higher price fluctuations compared to bonds or other asset classes, and a portfolio with a large portion of equities will naturally be more volatile.
2. Currency Exchange Risk: This is where many investors miss a crucial piece of the puzzle. The more a portfolio holds in assets that are denominated in foreign currencies, the greater the exposure to currency fluctuations. A portfolio consisting of international stocks, for example, will be subject to the risk of currency depreciation, which can lead to significant volatility.
In particular, the currency exchange risk is something that is not widely discussed in mainstream financial literature, especially when it comes to lazy portfolios. For example, a European investor who invests in US-based equity funds may find that fluctuations in the USD/EUR exchange rate impact the value of their investments in addition to the performance of the underlying stocks. This is because the returns from foreign investments are not only influenced by the performance of the market but also by changes in the exchange rate between the investor’s home currency and the foreign currency in which the asset is denominated.
Why Is Currency Exchange Risk Overlooked?
There are several reasons why currency exchange risk is often neglected, particularly by US investors:
1. Less Exposure for US Investors: For American investors, the currency risk is typically lower. This is because a significant portion of global equity markets (approximately 60%) is denominated in US dollars. As such, the average US investor does not face as much currency exposure. Even if they invest in international markets, the impact of currency fluctuations is less significant, with about 40% of the portfolio being potentially exposed to currency risks. Furthermore, many US investors tend to focus on domestic investments, which effectively mitigate this exposure.
2. Lack of Awareness: The concept of currency risk is often misunderstood or oversimplified by many investors and financial advisors. Most discussions around currency risk focus solely on its impact on returns—how exchange rate fluctuations can lead to either gains or losses—while the impact on the portfolio’s volatility is seldom explored in detail. This is particularly problematic because volatility is a key factor in determining the overall risk profile of an investment strategy.
3. Simplification by Financial Advisors: Many investors and advisors prefer to minimize the complexity of currency risk by assuming it is not a significant factor for long-term investors. The idea is that currency fluctuations tend to “average out” over time, meaning the investor is likely to experience little to no impact on long-term returns. This assumption, however, is flawed. While it may hold in some instances, the reality is that currency fluctuations can have a pronounced effect on the value of investments, particularly in shorter-term periods or during times of market stress.
Examining the Currency Exchange Risk in Lazy Portfolios
To understand the real impact of currency exchange risk on lazy portfolios, it’s important to analyze how it affects both the returns and the volatility of a portfolio. The following approach can help illustrate this:
1. A Deep Dive into 40 Lazy Portfolios: By performing backtests on 40 different lazy portfolios, we can assess how currency exchange risk impacts each one. The analysis will include portfolios in US dollars (USD), USD portfolios converted into euros (EUR) based on the daily exchange rate, and EUR-based portfolios designed for European investors.
2. Rolling 5 and 10-Year Returns: By analyzing the rolling 5-year and 10-year returns of each lazy portfolio, it becomes clear how the currency exchange risk can significantly affect long-term performance. These rolling returns give a clearer picture of how the portfolio would have performed across different periods, smoothing out short-term market fluctuations and showing how currency risk can impact overall returns.
3. Volatility of Currency Exposure: In addition to looking at returns, it is crucial to assess how the volatility of each portfolio changes when currency exchange risk is taken into account. Currency fluctuations can increase the volatility of a portfolio, making it more difficult for investors to maintain a steady and predictable performance, especially during periods of high market uncertainty.
Why Currency Risk Should Not Be Underestimated
The key takeaway here is that currency exchange risk should never be underestimated, especially when investing through a lazy portfolio. Ignoring currency risk can lead to unintended consequences, including higher-than-expected volatility and unpredictable returns. When building a lazy portfolio, investors should consider mitigating currency risk through strategies like diversification within the eurozone or hedging certain portions of the portfolio.
Furthermore, it is essential for investors to be aware of how currency exchange can impact their portfolios over the long term. By diversifying across asset classes and regions and carefully considering the currency exposure in each investment, investors can reduce the negative impact of currency fluctuations and achieve a more stable and predictable investment outcome.
Conclusion
In conclusion, lazy portfolios offer a simple and cost-effective investment strategy, but they come with risks that are often overlooked, particularly when it comes to currency exchange. By carefully considering the impact of currency fluctuations, investors can better manage the volatility of their portfolios and improve their long-term investment outcomes. As the old adage goes, “Don’t put all your eggs in one basket”—and in this case, that means not ignoring the risks posed by currency exchange.
In future articles, we will delve deeper into the nuances of lazy portfolios, provide more detailed analysis, and explore practical ways to manage and mitigate currency exchange risk for investors seeking a well-rounded, risk-managed portfolio.