Tips for Managing Currency Risk as an American Abroad
One aspect of living overseas that some U.S. expats fail to plan for is currency risk, or the risk that changes in the value of their country of residence’s currency will have a meaningful impact on their financial goals.
If you’re not taking steps to actively manage currency risk, it has the potential to impact multiple areas of your financial life as a U.S. expat, including your:
- Income –If you earn income in one currency and spend in another currency, exchange rates can have a substantial impact on your spending power. Unfavorable exchange rates have the potential to significantly decrease your net income in the other currency.
- Savings and Investments –If you’re saving and investing in a currency that’s different from the one you use to fund your lifestyle, changes in exchange rates can greatly impact the value of your investments, potentially leading to either gains or losses when converted.
- Cost of living –If the currency of your current country of residence is strong compared to the currency in which you saved your hard-earned wealth, you may experience a higher cost of living as you pay for daily necessities, such as groceries, mortgage or rent, transportation, healthcare, etc.
Following are some suggestions for how to mitigate the impact of currency fluctuations on your finances.
Access Now: Expat Guide to Investing and Financial Planning for Americans Living Abroad
Maintain a diversified, multi-currency portfolio.
Philosophically, we’re big believers in diversification, sometimes referred to as the only free lunch in investing. Just as your investments should be diversified across asset classes (such as stocks and bonds), stock market capitalizations (large vs. small), bond market maturities (short vs. long), and investment type (public vs. private), you should also diversify your investments across geographies (foreign vs. domestic) in order for you to obtain exposure to different economies and currencies.
Obtaining global diversification, and therefore investing in a multi-currency portfolio, is a great way for individual investors to hedge against currency fluctuations. In finance speak, this is sometimes referred to as “proxy hedging,” as the basket of currencies embedded in the investment portfolio creates a hedge by proxy.
It makes sense for Americans living abroad to maintain a diversified, multi-currency portfolio at a U.S.-based brokerage firm rather than opening multiple investment accounts in multiple countries. In addition to simplifying U.S. tax reporting requirements and keeping costs low, given the competitive U.S. financial system, investing in low-cost, tax-efficient investment vehicles, such as exchange-traded funds (ETFs), allows you to diversify your portfolio across multiple currencies while avoiding the pitfalls of international investing.
For example, investing with foreign brokerages can increase your risk of inadvertently investing in a passive foreign investment company (PFIC), which can be a tax nightmare for U.S. taxpayers. PFICs are subject to special, highly punitive tax treatment under the U.S. tax code. Not only is the tax rate applied to these investments much higher than that of similar or identical U.S. registered investments but the cost of accounting, recordkeeping and reporting for PFIC investments can easily lead to thousands of dollars per investment each year.
Remember, the key here is that “what you invest in” will determine the economic outcome of your investments, while “where you invest” can affect the tax consequences of your investments. U.S.-based ETFs are excellent tools to solve for both the “what,” by providing access to both U.S. and global investments, and the “where,” by being U.S. and country-of-residence tax-efficient.
Incorporate some currency matching.
Another key to managing currency risk is to match “life assets” to “life liabilities.” Life assets are the assets you accumulate through saving and investing with the understanding that you’ll one day draw down these assets to fund your lifestyle. Life liabilities are the big expenses you expect to incur in your lifetime, such as buying a house, paying for your child’s education and, ultimately, retiring. The expectation is that you’ll sell your life assets to pay for your life liabilities. Both life assets and life liabilities have a currency denomination.
A risk that many U.S. expats face is finding themselves with life assets and life liabilities of different denominations. In this situation, currency risk has the potential to significantly erode their life assets, making it more difficult to pay for life liabilities. This is why it’s important to match the currency of your assets and liabilities.
For example, if you are currently living and working in Europe but plan to retire in the United States, it may make sense to make sure your investment assets have more U.S. dollar exposure. Conversely, if you are living in the U.S. but plan to permanently move to Europe, it likely makes sense to maintain a meaningful portion of your assets in euro-denominated investments (which can be achieved via U.S.-based ETFs rather efficiently).
Keep in mind that, while it makes sense to match a portion of your assets to your future liabilities, a properly diversified portfolio will continue to span multiple currencies.
Hedging instruments – not suitable for all individual investors.
There are various hedging instruments designed to mitigate the risk of large currency swings, though there are issues with these solutions that make them largely ineffective for most individual clients. The main challenges in implementing any of the following instruments are access, cost, scale and basis risk.
Currency forwards, futures, swaps and options are instruments designed for institutional investors who intend to hedge very large sums of money to avoid the risk that changes in currency values will erode the spending power of the money on hand. Asset management firms also use these tools to hedge portfolio exposures, often times opportunistically. These synthetic instruments have what is known as “basis risk,” as the underlying currency isn’t specifically linked to the investment and there are often nuanced mismatches between the traded security and the underlying security, be they time, pricing or otherwise.
For the individual investor, while there are some currency exchange providers offering such hedging products, the individual should proceed with caution, as the fees involved are typically high. And currency trading isn’t for the faint of heart.
If you have a known expenditure in a specific currency in the near term, removing both currency and broad market risk by converting funds (at the current exchange rate) and putting the cash in a yield-bearing investment is often a great solution (so long as doing so doesn’t create tax complexity for the investor).
Here are several instruments available to sophisticated institutional investors:
- Forward contracts – Forward contracts establish a price and date for a future currency transaction. These vehicles are fully customizable, privately arranged and deemed to be settled at the conclusion of the contract.
- Future contracts – Future contracts represent formal agreements between two investors who wish to buy or sell currency at an agreed-upon price at a certain date in the future. These vehicles are traded on a futures market in standard sizes and quantities.
- Swaps – Currency swaps are arranged by negotiating an exchange rate with another investor hoping to make a reciprocal transfer.
- Options – Options offer investors an opportunity to purchase an asset, such as foreign currency, at a predetermined price. They provide additional flexibility because the buyer has the “option” of whether to exercise the right to purchase.
Could you use help managing currency risk as a U.S. expat? Creative Planning International is here for you. We specialize in helping expats and cross-border families maximize their wealth and avoid costly mistakes. We understand the complex interaction of multi-jurisdiction tax and regulatory regimes and help clients develop operationally and financially efficient wealth management strategies customized to their unique set of circumstances. Because we serve in a fiduciary capacity, you can be confident we’re acting solely in your best interests.
