Many investors use international mutual funds as a hedge against a downturn in the U.S. economy. However, international funds can create more problems than solutions if an economic upturn causes the value of the dollar to skyrocket. Certain kinds of international funds are more susceptible to currency fluctuations than others.
An international mutual fund is a pool of securities that were issued in nations other than the United States. Income funds contain foreign government bonds and corporate debt, while growth funds contain stocks in foreign companies. You can buy funds based on geographic regions as well as on different types of securities. For example, some funds contain energy stocks from all over the globe while others contain bonds only from certain geographic regions. International funds containing securities from developing nations tend to experience more price volatility than funds holding just European or Japanese securities.
When a mutual fund acquires assets in a particular nation, those assets are generally priced in that nation's currency. However, if the fund itself is registered in the U.S, its shares must be priced in dollars. Mutual fund share prices are established daily at the close of the New York Stock Exchange. At that time, fund manager's calculate the underlying value of the fund's holdings such as stocks and bonds. The net asset value of each share is calculated by dividing the fund's total worth between the outstanding shares. In an international fund, the value of the securities is converted from euros, yen or other currencies into U.S. dollars.
Share prices of international funds decrease when the value of the U.S. dollar rises. If one British pound sterling is worth $2 then a 1,000-pound government bond is worth $2,000. If the value of the U.S. dollar doubles, the bond is still worth 1,000 pounds but it is only worth $1,000. The actual value of fund assets as denominated in foreign currency can remain exactly the same even while your shares plummet in value. Investment professionals refer to danger of exchange rate related losses as currency risk.
Both domestic mutual funds and international funds expose investors to currency risk. In contrast, a global fund can protect you from fluctuations involving the dollar. Like an international fund, a global fund contains securities from around the world. Unlike an international fund, it also contains U.S. securities. When the dollar rises, the foreign securities in the fund lose value but the market value of the U.S. securities rises. Depending on the exact makeup of the fund, rising U.S. asset prices may more than offset losses tied to your foreign holdings.