From the July 2006 issue of Investment Advisor • Subscribe!

The Currency Conundrum

As if investors don't have enough to worry about as they wrestle with the proper allocation of stocks, bonds, commodities, and hedge funds, and philosophical questions regarding passive versus active management, here comes another beast to tackle--currency exposure.

We should blame this problem on the stellar returns of global equities. Quick to ride the gravy train, many U.S. investors have committed significant capital to both emerging and international mutual funds. The result has been increased interest on the direction of the U.S. dollar, which can significantly affect the value of such investments depending on whether currencies rise or fall in value.

Central to the currency conundrum is the fact that if one buys foreign securities, they must do so with the currency in which that asset is denominated (i.e., British stocks are purchased with British pounds, etc.). As a result, a domestic investor with a foreign portfolio is making an implicit bet that the dollar will lose value relative to the currency of the host country in which he is investing.

That's been a pretty good bet to make, as the greenback has lost ground to most major currencies over the last few years. But the recent surge in the dollar's value has surprised a plethora of market experts, who expected further declines as the nation's twin deficits increase. If the U.S. economy continues experiencing strong growth, the Federal Reserve might be forced to raise short-term rates even higher, which could create a sustained dollar rally.

Investors facing such a dilemma have several choices. One solution is to utilize a fund that hedges away its currency risk. There is a plethora of global bond funds that hedge away such exposure, and their returns are much less volatile than those for unhedged bond funds. However, unhedged funds can be a real return driver when the dollar falls. In the end, it all comes down to the investor's objectives and their expectations for the dollar.

In the case of international equity funds, hedging ends up not making much difference. The volatility of the underlying stocks is so great that, over the course of a few years, the difference in return between unhedged and hedged funds is minimal. As a result, the bulk of these types of funds don't bother with the extra expense of hedging their currency exposure. Short-term performance is likely to be different, though, and in some cases can be dramatically different. Ensuring that clients are comparing apples to apples when it comes to hedged and unhedged funds is vital.

Wall Street's securitization craze has allowed for a new way to deal with currency exposure. Rydex Investment's new Strengthening Dollar and Weakening Dollar Funds allow investors to easily express their views on the greenback with the press of a button. Similar funds by Merrill Lynch, Profunds, and Rafferty Management are also available. But in all cases, investors must decide for themselves the most likely direction for the dollar, and for most folks, that's about as easy as picking a winner at the track.

Perhaps the biggest decision for advisors is to determine whether currencies should be considered a separate asset class from equities, fixed income, and alternatives. A few Wall Street firms have done just that, recommending that investors place a small percentage of their assets in euros and British pounds. I find this argument a little hard to swallow, since unlike stocks and bonds, currencies have not been shown to appreciate with economic growth. Currency trading seems every bit as tricky and unpredictable as trading individual stocks (see graph below).

Further, currency movements frequently fly in the face of logic. The dollar has been in a steadfast decline this year even as domestic interest rates have risen. A few years ago, the governor of the Bank of England, Mervyn King, commented that he had "no idea where exchange rates will go in the future." Similarly, Alan Greenspan likened currency trading to "forecasting the outcome of a coin toss." If two of the world's leading figures in central banking can't guess the direction of the dollar, I'd be inclined to sit on the sidelines.

The Puzzler, CIO of Memphis-based Sovereign Wealth Management, can be reached at puzzler@investmentadvisor.com.

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