From the January 2010 issue of Research Magazine • Subscribe!

Dealing with the Dollar

The depressed state of the U.S. dollar has turned the cost of your foreign excursions from a small fortune into a major one.

If you've been flirting with the idea of finally taking that coveted European vacation, you might want to wait. The depressed state of the U.S. dollar has turned the cost of your foreign excursions from a small fortune into a major one.

Despite tough talk from Treasury Secretary Timothy Geithner and other federal officials about a strong dollar being in the best interest of America, the dollar continues to sag further and further into the mire. Is oblivion the next stop?

The dollar's drop isn't worrying just Americans, but the world abroad. Thailand, South Korea, Russia and the Philippines were recently net buyers of the dollar. This was seen as a move to hold down the value of their respective currencies. If those currencies become too strong relative to the dollar, it hurts the ability of these countries to compete for business as their exports become too costly.

China's currency, the yuan, is linked to the dollar. As the yuan falls in value with the dollar, China creates a competitive advantage for itself by keeping its export prices lower. While China may flourish, other regions like Europe are growing considerably uncomfortable with a depressed dollar. A strong euro comes at the cost of unaffordable exports for American consumers. The end result is lackluster business.

Currency Choices

From an investment perspective, how can you help your clients to successfully combat a weakened dollar? Let's evaluate some strategies for dollar hedging.

Besides providing securities diversification, almost all index funds and index ETFs provide currency diversification too. Unlike actively managed funds, which sometimes hedge with currencies, index funds provide unhedged currency exposure. Simply put, the foreign securities inside index funds are priced in local currency.

Foreign-stock ETFs that are a good foundation for non-US equity exposure and currency diversification include the SPDR MSCI ACWI ex-US ETF (CWI) and the Vanguard All World FTSE Ex-US ETF (VEU). Single-country ETFs like the iShares FTSE/Xinhua China 25 (FXI) and the Market Vectors Russia ETF (RSX) also provide the foreign exposure, but with higher volatility.

"Many investors invest their equity-earmarked money solely in U.S. stocks, thinking non-U.S. investments are inherently more risky," says Joseph Childrey, managing partner with Childrey Investment Partners in La Jolla, Calif. "In recent years, the correlation between U.S. and non-U.S. markets has increased and the standard deviation [risk] is about the same. Therefore we feel investors who ignore the foreign markets are missing out on investment opportunities."

Don't overlook foreign bonds too. Tom Anderson, head of strategy and research at State Street Global Advisors, emphasizes that foreign inflation-protected securities (WIP) are useful for U.S. investors seeking inflation protection minus dollar exposure. State Street also manages an international Treasury bond fund (BWX), which was up 8.51 percent through October.

The falling dollar has attracted a lot of excitement among commodity investors, particularly the gold enthusiasts known as goldbugs. Since commodities are priced in dollars, their value rises when the dollar declines. This partly explains the resurgence in gold prices (GLD), which hover around $1,100 per ounce. Since the beginning of 2009, GLD has gained around 25 percent.

For broader market exposure to a basket of commodities, one possibility is the Greenhaven Continuous Commodity Index Fund (GCC), which offers equal weight positions to 17 different commodities. Each commodity is assigned a 5.88 percent index weighting and rebalanced daily.

Clients not comfortable with owning an asset that has no dividends or earnings can look to industry sectors closely tied to the performance of gold and raw commodity goods. For example, the Select Sector Materials SPDR (XLB) owns S&P 500 companies involved in the agriculture and mining business. The Market Vectors Gold Miners ETF (GDX) owns large-cap mining stocks and the Market Vectors Junior Gold Miners ETF (GDXJ) focuses on small-cap mining stocks.

According to ETFguide.com's online database, there are 27 currency-focused ETFs and ETNs. Certain funds, like the PowerShares DB US Dollar Bearish Fund (UDN), are designed to increase in value when the dollar declines.

Rydex SGI offers nine currency ETFs. The oldest and largest of these is the CurrencyShares Euro Trust (FXE). FXE is linked to the performance of the euro, which has solidly outperformed the dollar. In addition, the CurrencyShares Australian Dollar Trust (FXA) has jumped significantly along with the Canadian Dollar Trust (FXC). Owning these currency ETFs makes you short the dollar versus that respective currency.

Greenback Outlook

What's bad for the dollar is good for gold and non-dollar-denominated assets, but other structural changes may be at work.

In October 2009, The Independent, a British newspaper, reported secret meetings between Arab states, China, Russia, Japan and France to end the practice of oil being priced in U.S. dollars. Sources of the unconfirmed meeting also said baskets of currencies including the euro, the yen and the Chinese yuan were being considered as alternatives. While no one knows if the dollar will lose its coveted status as the world's reserve currency, your clients' investment portfolios should be prepared for that possibility.

"The short-term concern I have with the U.S. dollar and the way investors have built portfolios is a rally in the dollar is going to correspond with a correction in the markets, as there has been an inverse correlation," states Suzanne Hamilton, president of Legacy Asset Management in Washington D.C. "I have actually started to go long the dollar in client portfolios and hedge fund. My models will keep me long or short the dollar depending on the trend at the time."

The dollar's demise isn't just another thing for advisors to think about, but something to act upon too. No one knows how much longer dollar weakness will persist, but you should prepare your clients to combat its wealth-eroding impact.

Educating clients about the vital role of assets like commodities, gold, foreign currencies and securities can help them appreciate and understand your investment plan. If they still don't get it, use a free online currency converter to show them the value of the dollar versus the euro. To acquire an asset that costs 10,000 euro would take around $14,900. The only logical way to fight the purchasing power loss of dollars is to hedge.

Childrey says: "In addition to our slightly over-allocating commodity and real estate exposure for our portfolios, we recommend that our clients make sure that their assets are properly allocated to match their risk threshold, regardless of the dollar's next move."

Well-designed investment portfolios don't happen by accident. They should reflect more than just stock and bond diversification. Investors should also have adequate currency diversification. As we've just considered, obtaining this is easily accomplished by owning foreign ETFs, currency ETFs or commodity-related ETFs. The financial tools exist; now it's up to you to successfully utilize them.

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