How currency affects US fund returns

• Currency fluctuations impact returns for Indian US fund investors
• Rupee depreciation can amplify gains, while strengthening cuts them
• Investors can choose hedged funds to reduce currency volatility risk

Ever invested in a US-focused mutual fund and wondered why your returns don't perfectly match the S&P 500's performance? There’s a powerful, often overlooked factor at play: the currency exchange rate. Here’s what you need to know.

The Two Engines Driving Your Returns

When you invest in an international fund from India, your final return in rupees is driven by two distinct engines working together. The first is the performance of the underlying asset—the stocks or bonds in the fund. This is the part we all watch closely, like a company's profit growth or a stock market's index level. The second, and equally important, engine is the movement of the exchange rate between the Indian Rupee (INR) and the currency of the country you're investing in, most commonly the US Dollar (USD). You are effectively making two bets: one on the foreign asset and another on the currency.

A Tale of Two Currencies

Let's walk through a simple example. Imagine you invest ₹8,500 in a US-focused fund when the exchange rate is ₹85 to $1. Your rupees are converted, and the fund manager invests $100 on your behalf. Now, let's say the fund's assets perform brilliantly, growing by 10%. Your investment is now worth $110. This is the asset performance part. But to realize your gains, that $110 must eventually be converted back into rupees. The final amount you receive depends entirely on what the exchange rate is on the day of conversion. This is where the second engine kicks in and can significantly alter your outcome.

When the Rupee Weakens: A Tailwind for Your Portfolio

Historically, the Indian Rupee has tended to depreciate against the US Dollar over the long term. Let's say that during your investment period, the rupee weakens, and the exchange rate moves from ₹85 to ₹95 per dollar. When your $110 investment is converted back, you don't get ₹9,350 (which would be a simple 10% return on ₹8,500). Instead, you get $110 multiplied by the new rate of 95, which equals ₹10,450. Your initial ₹8,500 investment has grown by ₹1,950. This translates to a total return of 22.9% in rupee terms, much higher than the 10% gain the US assets delivered. In this scenario, the weakening rupee acted as a powerful tailwind, amplifying your gains.

When the Rupee Strengthens: A Headwind to Gains

Now let's consider the opposite scenario. What if the Indian economy is booming, and the rupee strengthens against the dollar? Suppose the exchange rate moves from ₹85 to ₹80. Your $110 investment, when converted back to rupees, will now only fetch you ₹8,800 ($110 x 80). In this case, your original ₹8,500 investment only grew by ₹300, giving you a modest return of just 3.5%. Even though the US assets did well, the strengthening rupee acted as a headwind, significantly eating into your returns. This is the currency risk that every international investor must be aware of.

To Hedge or Not to Hedge?

So, what can you do about this? Some funds try to neutralize this currency effect through a process called hedging. A currency-hedged fund uses financial instruments to lock in an exchange rate, ensuring your returns closely mirror the underlying asset's performance. This is useful for short-term goals or for investors with a low risk tolerance who want to avoid currency volatility. However, hedging isn't free; it adds to the fund's expense ratio. For long-term investors, many argue that an unhedged approach is better. Since the rupee has historically depreciated, unhedged funds have often provided an extra kicker to returns. By hedging, you might be protecting yourself from a headwind but also giving up a potential tailwind.