By holding a variety of assets, the likelihood (risk) of one area performing badly and adversely affecting the entire portfolio is much lower.
However, being 'exposed' to international markets through investment automatically brings about another risk, that of foreign currency. In other words, returns become dependent not only on the change in the asset's value, but also on the value of the local currency versus the New Zealand dollar.
Take the example where a New Zealand investor purchases one IBM share for US$100, and 12 months later sells the share for US$110 - a return of 10% in US dollars.
However, if over the same period the New Zealand dollar strengthened by 10% against the US dollar, this would completely 'cancel out' the initial return once the share was sold and the money converted back to New Zealand dollars.
On the other hand, had the US dollar strengthened 10% versus the kiwi, the investment would have returned around 20%, i.e. 10% from the gain in the IBM share and 10% from the currency movement.
Such uncertainty can be removed or reduced by 'hedging' the currency risk using a 'forward foreign exchange contract'. Hedging essentially means to protect against losses.
So, to continue the IBM example, at the same time the investor purchases his share (i.e. converting his New Zealand currency to obtain US$100), the same amount of New Zealand dollars are bought (i.e. US$100 is sold) at a future date in a forward foreign exchange contract.
This effectively 'locks in' the current exchange rate for the term of the investment, meaning it is no longer exposed to currency fluctuations.
How does that work? If the New Zealand dollar strengthens, the forward contract will result in a gain when it is 'closed out' by selling the investor's New Zealand dollars at the higher rate. If the New Zealand dollar falls (in which case the investment is worth more in New Zealand dollars), the forward contract will result in a loss when the New Zealand dollars are sold at a lower rate.
In either scenario, the return on the investment will simply be the 10% gain from the increase in the IBM share price.
Taking that one step further, an investment in a foreign asset can be hedged in one of two ways; passively or actively.
Passively means setting a hedging level at the outset that will stay in place for the duration of the investment. Active hedging involves setting a range around a target level, which means the level can be adjusted depending on which way the currency is expected to move.
By setting the level at 100% (or 'fully' hedging), all currency risk is removed and the investment return will come solely from the underlying asset's performance. This level is typically applied to the more stable, income-generating assets such as fixed interest and property.
However, the more volatile the asset, the less impact currency movement will have on the investor's real return. In this case, the hedge could be set at say 50%, with an option (known as an active currency overlay) to adjust the hedge within a set range.
That gives the fund manager some scope to capitalise on the currency's movement, based on their estimation of which way it will go. If their forecast is correct, then the gains from the active hedging position will be added to the basic return from the underlying asset.
In summary, diversification through international investment brings with it the additional complication of currency risk. This can be mitigated using forward foreign exchange contracts - and even capitalised on through active currency hedging - in an effort to protect and augment an investment's return.
ING uses both active and passive hedging strategies in respect of the international assets held in its funds.