How Currency Fluctuations Drive Overseas Investment Returns
When a Japanese investor buys U.S. equities, the return is affected not only by stock price movements but also by USD/JPY exchange rate fluctuations. For example, even if the S&P 500 rises 10% in a year, if the yen strengthens from 150 to 135 per dollar over the same period (a 10% yen appreciation), the yen-denominated return is virtually zero. Conversely, if the yen weakens, you enjoy the double benefit of stock price gains and currency gains. During the yen depreciation phase from 2022 to 2024, yen-denominated returns on U.S. stocks significantly outpaced dollar-denominated returns.
The magnitude of currency risk varies by currency pair. The annual volatility of USD/JPY has averaged around 8-10% over the past 20 years, while emerging-market currencies can reach 15-20%. Given that the expected return on developed-market equities is around 5-7% per year, currency fluctuations are a factor that can dominate a large portion of returns and cannot be ignored.
Sorting Out the Criteria for Currency Hedging
Currency-hedged investment trusts reduce the impact of exchange rate movements but incur a hedging cost. This cost is linked to the short-term interest rate differential between Japan and the U.S., and as of 2024 it runs at about 4-5% per year. In other words, even if the expected return on U.S. equities is 7% per year, after deducting the hedging cost the effective return drops to 2-3%. When the interest rate differential is large, hedging costs can severely erode returns.
For long-term investors, going unhedged is often the more rational choice. Books on international diversification in practice show that over horizons of 20 years or more, the impact of currency fluctuations becomes relatively small compared to equity returns, and the cumulative burden of hedging costs tends to outweigh the benefit.
Strategies for Yen-Weak and Yen-Strong Environments
During a yen-depreciation phase, the yen-converted value of overseas assets swells, expanding unrealized gains. However, adding to overseas assets at this point carries the risk of suffering currency losses if the yen later strengthens. A period of yen weakness is actually a good time to review the proportion of domestic assets and yen-denominated bonds. On the other hand, a yen-appreciation phase is an opportunity to purchase overseas assets at a discount. If you are dollar-cost averaging into overseas assets on a regular basis, you automatically acquire more units when the yen is strong, which lowers your long-term average acquisition cost.
Predicting the direction of exchange rates is difficult even for experts. Books on foreign-currency assets and portfolio construction also recommend that the best way to deal with currency risk is to diversify across multiple currencies and smooth out purchase timing through time diversification.
Practical Steps to Start Managing Currency Risk Today
To begin addressing currency risk, start by checking the currency composition of your portfolio. From your brokerage account's holdings list, calculate the ratio of yen-denominated assets to foreign-currency-denominated assets. If foreign-currency assets exceed 50% of the total, the impact of exchange rate movements is significant, and it is worth considering adding domestic bonds or yen-denominated assets. Conversely, if foreign-currency assets are below 20%, consider increasing the proportion of overseas assets from a global diversification perspective.
As a practical action, the simplest approach to overseas investing is to dollar-cost average a fixed amount each month. By continuing to purchase a fixed yen amount regardless of the exchange rate, your average acquisition rate is smoothed out. If you invest 3 man-yen per month into a U.S. equity index fund, you buy roughly $230 worth in a month when the rate is 130 yen per dollar and roughly $194 worth when it is 155 yen per dollar - automatically buying more when the yen is strong.