Follow these four rules so you don't get sideswiped by foreign currency risk.
1. Look for countries with strong, rising currencies.
High debt usually precedes high inflation, Carrillo says. And when inflation kicks in, currencies usually fall as confidence in them declines. However, countries with low debt to GDP have rising currencies, which can be profitable for U.S. investors.
"Make sure you pick an economically sound country and stick with it," Carrillo says. "If there's a big devaluation in the dollar, foreign stocks will also do well."
2. Know that foreign bonds can be especially hard hit.
Bonds are especially vulnerable to currency fluctuations, since they have lower gains to offset currency losses.
"When investing in a foreign bond index, currency fluctuations can be plus or minus 10 percent," says Ed Boyle, senior portfolio manager for American Century Investments in New York City. "These changes are double what a bond may return." To be sure, however, there's less effect on equities since they can have higher returns.
Scott Stratton, president of Good Life Wealth Management LLC, agrees. Currency fluctuations have a much greater impact on foreign bonds than changes in the bonds' prices, he says. Historically, most foreign-country bonds were issued in dollar valuations, Stratton says. Today, many are issued in local currencies. Still, investors can find bonds issued in dollars, and that can be a more stable investment.
3. Invest in currency-hedged funds.
The best way to protect your foreign returns is to invest in mutual funds or exchange-traded funds that are hedged, says Boyle. These funds usually use sophisticated investments like futures and options to hedge the currency risk of a bond or equity, and reduce losses.
Many new ETFs that hedge currencies have been introduced within the past year, says Neena Mishra, director of ETF research at Zacks Investment Research. Now, currency-hedged ETFs are available in almost any region of the world, including emerging markets, Germany and Japan. For example, the WisdomTree Japan Hedged Equity Fund hedges currency fluctuations between the dollar and the Japanese yen.
Currency-hedged ETFs can cut into returns while also lowering your losses, Mishra says. "They are slightly more expensive than non-hedged ETFs," she says. "On the upside, currency-hedged ETFs are less volatile than ones that do not hedge. So, it's one of the most important ways to protect yourself from losses."
4. Diversify globally.
If you have lots of investments in foreign securities, make sure you have investments in a basket of regions, rather than in just one region, Boyle says. "So if you have lots of exposure in Europe, that can be a bad thing," he says. "Instead, diversify across different geographic regions."
Mishra says another option is to invest in regions where the currency is pegged to the dollar. For example, several Middle Eastern countries, including Lebanon and Saudi Arabia, peg their pounds and riyals to the dollar. Conversely, several African countries, such as Senegal and Cameroon, peg their currencies to euros. "That's another way to diversify holdings," she says.