January 12, 2005  Email this  Print this
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HEDGES
Coping With a Dwindling Dollar
by Anne Kates Smith
The U.S. dollar may be shrinking in value, but that doesn't mean your portfolio has to. Investors with a savvy currency strategy can protect their portfolios from a dollar disaster, and maybe even earn a buck (or a euro or a yen) or two. Since peaking in 2002, the dollar has lost about one-fourth of its value, as compared with a basket of other currencies. The pressure comes from a pair of incorrigible twins: the growing U.S. budget deficit and the enormous current-account deficit. The latter is a broad measure of trade, as well as the flow of investments, between countries. Our appetite for imported goods was expected to swell the current-account deficit in 2004 to a record high of $665 billion -- more than 5% of the U.S. economy. How can we afford to buy so much more than we are selling overseas? Foreign investors are subsidizing the spending spree by buying boatloads of Treasury bonds that must be issued to finance the budget deficit.
A weaker dollar, which makes U.S. exports more affordable in foreign markets and foreign-made goods more expensive in the U.S., is one cure for the trade imbalance. But that's a turnoff to foreign investors because a shrinking dollar means that their investments here translate into fewer euros, yen or the like back home. If, as a result, foreigners dump dollar-denominated assets, it could turn the dollar's orderly decline into a rout marked by skyrocketing interest rates (to defend the dollar and combat soaring inflation that could result from more expensive imports). Ultimately, economies around the globe could slow as American consumers retrench and export-driven markets languish overseas.
We don't anticipate such a worst-case scenario. Rather, we expect a decline over the next couple of years on the order of 15%, bringing with it moderate increases in inflation and interest rates. But don't be fooled by a short-term dollar rally. Over the long haul, you'll want to protect your portfolio from a declining dollar.
Play the currency swing
Mutual funds that invest overseas can deliver more bucks for the bang. As the dollar weakens, your investments in foreign securities convert to more greenbacks.
A recent study by fund-tracker Lipper found that overseas bond funds are more sensitive to dollar swings than foreign stock funds. T. Rowe Price International Bond (RPIBX; 800-638-5660) tops the list of beneficiaries of a falling dollar. Over the past three years to December 1, the fund returned 15% annualized. Nearly two-thirds of that gain came from a diving dollar. Another solid choice: Loomis Sayles Global Bond fund (LSGLX; 800-633-3330). The fund's foreign picks yield more than comparable U.S. bonds do, so currency gains are gravy. The fund returned an annualized 16% over the past three years.
Stock funds are more complicated. As with foreign bond funds, you reap currency-translation gains if the dollar sinks. At the same time, though, a falling buck can pinch profits of foreign companies. For diversification's sake, roughly 20% to 25% of long-term investors' equity stake should be in foreign holdings anyway -- the recent dollar debacle just proves the rule. Solid overseas stock funds include Julius Baer International Equity A (BJBIX; 800-435-4659), Dodge & Cox International (DODFX; 800-621-3979) and Third Avenue International Value (TAVIX; 800-443-1021). Baer returned an annualized 16% and Dodge &Cox, 19%, over the past three years. Third Avenue doesn't have a three-year record but soared 55% in 2003 and 25% in 2004 to December 1. These funds generally do not hedge their foreign-currency exposure, a tactic that trims or eliminates currency gains in a falling-dollar environment.
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