Bobby Arrington, a semi-retired software engineer in Plano, Texas, enjoyed his latest trip to Italy a little more than a year ago-what he didn’t enjoy was the hit to his wallet. “For my wife, Tita, and me to buy round-trip train tickets between Florence and Rome, the cost was around $110,” he says.
Now the Arringtons are planning a trip to the Philippines. “A few years ago, we could get 52 pesos to the dollar,” says Arrington, 59. “Now I’m expecting a dollar will bring as little as 38 pesos. Everything will be more expensive.”
Indeed, the declining value of the U.S. dollar has been in the news for several years. What does a crumbling currency mean for U.S. investors? Dan Lefkovitz, a senior mutual fund analyst at Morningstar, a Chicago-based research firm, provides this illustration: Think back to 2002, when the dollar began to drop. Assume you invested in a fund designed to track the MSCI EAFE Index, the most popular benchmark for foreign stocks. What’s more, suppose you invested in a hedged version of this fund, meaning that all currency fluctuations were stripped out. Over the next five years, to the end of 2007, you would have enjoyed a 10.4% annualized return. Not bad. But if you had invested in the same fund without the currency hedge, and thus enjoyed upward movements in pounds, euros, and Swiss francs, your annualized return would have been 16%.
To put that in perspective, a $10,000 investment grows to around $17,200 in five years, at a 10.4% rate. At a 16% rate, though, that same $10,000 grows to more than $22,700. The $5,500 difference would be attributable to currency fluctuations.
Focusing on funds
If you believe that the U.S. dollar will stay weak or may fall even further, one way to bet against the buck is to buy foreign funds without the currency hedge (most foreign funds fall into that category). In fact, that’s the strategy currently embraced by the Arringtons.
“My financial planner, Kevin Davis, suggested in 2006 that I invest in international funds,” says Arrington. “I did, and I’m very pleased with the results so far.” Davis, a certified financial planner with Dallas-based Consolidated Financial Services, says his research led him to conclude that a global portfolio could outperform one that was domestically oriented. “Growth outside the U.S. may exceed economic growth here,” he says. If America is a relative laggard, the U.S. dollar also could continue to decline. In such a scenario, foreign stocks and funds would post superior returns. “My clients tend to have 20% to 40% of their portfolio in foreign funds,” says Davis. “Bobby Arrington is at the upper end of that range. With his risk tolerance and his modest spending habits, he can be more aggressive.” Arrington’s portfolio now includes a diverse range of international offerings from American Funds: EuroPacific Growth (AEPGX), New World (NEWFX), Capital World Growth & Income (CWGIX), and Capital Income Builder (CAIBX).
“Today, having a domestic-only portfolio may be too risky,” says Leslie Williams, a financial adviser with Ameriprise Financial in Woodbridge, Connecticut. If the dollar is devalued further, then holding all your money in U.S. securities means you risk losing purchasing power.
With even more international allocation in their portfolio are Williams’ clients Linda and Jerry Guyden of Easton, Connecticut. “We have about two-thirds of our assets outside the U.S., and we might go even higher,” says Linda, 54, a former corporate executive now on sabbatical. “We’ve always felt the market is global, so that’s where you should invest. We believe there’s a good chance that the U.S. dollar will continue to fall, so concentrating in the U.S. may be even riskier now.”
Jerry, 55, a professor at City College of New York, cites corporate governance issues as contributors to their desire to de-emphasize U.S. investing. “After Enron, WorldCom, and a slew of others, we don’t have as much trust in U.S. companies as we once did.”
Emphasizing ETFs
Investors wishing to diversify from U.S. holdings have more options these days. “We’re gradually switching from mutual funds to exchange-traded funds (ETFs), says Allen Gillespie, principal of GNI Capital in Greenville, South Carolina, who manages the Generation Wave Growth fund (GWGFX)-which has boasted an average annualized return of 13.28% for the last five years. Compared with traditional mutual funds, ETFs often have lower costs; increased transparency; and what Gillespie calls “granularity,” the ability to make narrowly focused bets.
For example, Gillespie’s fund holds iShares MSCI EAFE (EFA) and iShares MSCI Emerging Markets Index (EEM), two ETFs that track broad indexes of foreign stocks. In addition, the fund holds WisdomTree Japan SmallCap Dividend (DFJ), which invests in small Japanese companies that pay dividends. “We think the
yen is undervalued versus the dollar,” says Gillespie. “People will be doing more business in Asia and there will be more demand for the region’s currencies, including the yen, which may appreciate. We also believe this sector of the Japanese market looks cheap. With this ETF, we buy the currency and the stocks.”Other ETFs permit you to buy the currency without the risk or potential reward of the underlying stocks. Rydex Investments, for example, offers eight CurrencyShares ETFs, permitting you to invest in euros, pounds, yen, Swiss francs, Mexican pesos, Swedish kronor, Canadian dollars, or Australian dollars. “Institutional investors have had these kinds of opportunities for years,” says Tim Meyer, ETF business manager at Rydex in Rockville, Maryland. “Now, individual investors have products they can use to reduce their exposure to the U.S. dollar.”
When you buy one of these ETFs, your money goes into an interest-bearing bank account, denominated in that currency. You’ll get the yield from that account, plus or minus the currency move. Suppose, for example, you invest in CurrencyShares Australian Dollar Trust (FXA), which, Meyer says, has a great appeal lately because of Australia’s commodity-based economy and expectations that it will benefit from its proximity to China as that economy continues to grow. As of early January, investors were earning 6.10%. If the Aussie dollar gains 10% versus the U.S. dollar this year, the total return to U.S. investors would be 16.10%. (On the other hand, a 10% gain by the U.S. dollar would result in a net loss for U.S. investors.)
If you’d rather not pick
and choose among currencies, Deutsche Bank offers PowerShares DB US Dollar Index Bearish (UDN). There’s also PowerShares DB US Dollar Index Bullish (UUP), for contrarians, and PowerShares DB G10 Currency Harvest fund (DBV), which follows a strategy designed to produce high returns by moving in and out of futures contracts. “With UDN, the bearish ETF, we buy U.S. Treasury Bills,” says Kevin Rich, CEO of DB Commodity Services in New York. With the T-bills as collateral, the ETF engages in futures trading. If the U.S. dollar falls against an index of six foreign currencies, this bearish ETF will make money from its futures trading.While such ETFs provide a direct way to profit from a weaker dollar, any profits are likely to be highly taxed. For example, the Rydex currency ETFs are treated like bank accounts, so any gains are taxed at ordinary income rates, not the bargain rates on long-term capital gains.
The PowerShares currency ETFs are taxed like futures contracts, which means that any paper profits are taxed each year-as a mix of long- and short-term gains-even if you haven’t sold your ETF shares. What’s more, those commodity-like tax results are reported on an unfamiliar form (called a K-1) that you or your tax preparer will have to deal with.
In the end, before you purchase such an ETF, ask your financial planner about
the tax implications. The U.S. dollar may be losing ground but you can be sure that the U.S. Internal Revenue Service hasn’t lost its desire to collect every dollar it can.