Currency Plays For The Retail Set

Dodge & Cox is not famous for making dramatic contrarian moves. Instead, the company's funds have become popular by following cautious strategies, such as buying “high-quality” securities. But recently Dodge & Cox International Stock announced a change in policy. At a time when most experts expect the dollar to keep sinking, the Dodge & Cox fund is using futures to bet that the U.S. currency will rise. “They decided that the dollar is too cheap, and it is due for a rebound,” says Gregg Wolper, senior analyst for Morningstar.

Like Dodge & Cox, many investors are reviewing their currency positions. With the dollar swinging erratically, currency bets can have a significant impact on portfolio returns. While it is possible to buy currencies directly, many investors are turning to mutual funds and exchange-traded products that make it possible to bet on a rising or falling dollar.

To benefit from a falling dollar, consider buying a foreign-equity fund. When the dollar sinks, the value of overseas stocks in the typical fund increases for U.S. investors. In recent years, the falling dollar has provided a significant boost for foreign funds. During the six-and-a-half years ending in 2007, foreign funds returned around 10 percent for U.S. investors; about half that result came from the currency gains that were generated by the falling dollar. The “currency effect” largely explains why foreign stocks outdid the S&P 500 during the period.

Funds That Hedge

Suppose you agree with Dodge & Cox, and figure that the dollar is about to rebound. If that happens, the vast majority of foreign funds will face a headwind as the value of their foreign holdings sinks for U.S. investors. To avoid currency losses, consider one of the handfuls of funds that hedge their currency exposure. A solid choice is Tweedy, Browne Global Value. The fund uses forward contracts, which lock in currency values, and ensure that the fund will not suffer losses if the dollar strengthens. Tweedy's goal is to provide steady returns — while sheltering shareholders from the sharp rises and falls of the currency markets. Other top funds that hedge their exposure are Mutual European, Longleaf Partners International and First Eagle Overseas.

To fine-tune your currency exposure, consider CurrencyShares, exchange-traded products offered by Rydex Investments, that track a variety of currencies. A share of CurrencyShares Euro represents a stake in a deposit of 100 euros. During the 12 months ending in March, CurrencyShares Euro returned 22.2 percent. Along with the euro, investors can select from eight other CurrencyShares, including products representing Australian dollars, Japanese yen and Swiss francs.

Holding the CurrencyShares proved profitable last year for clients of Carmine D'Avino, vice president of Pinnacle Associates, a registered investment advisor in New York that clears trades through Charles Schwab Institutional. D'Avino put 5 percent of some portfolios into a basket of currencies that included the euro and yen. “We took the position because it seemed clear that the dollar was going to continue declining against major currencies,” says D'Avino.

While some advisors hold CurrencyShares for short-term gains, others maintain long-term holdings of currencies for diversification. As the markets demonstrated in recent months, currencies don't necessarily track stocks, and foreign currencies sometimes rise when the S&P 500 is falling. The diversification of foreign currency can be particularly important for clients who plan to leave the United States in the future for overseas postings, or to retire in another country, says John Duy, research analyst for Wilbanks Smith and Thomas, a registered investment advisor in Norfolk, Va., that also clears trades through Charles Schwab. A client who keeps his entire portfolio in dollars could suffer a jolt when he must pay bills in Europe or Asia.

Duy has a U.S.-based client who expects to return to his native India in 10 years. For diversification, Duy keeps some of the client's assets in CurrencyShares. “This client is worried about the declining dollar, so we are holding a variety of currencies to protect his purchasing power,” says Duy.

CurrencyShares represent interest-bearing deposits. Current yields include 3.63 percent for the euro, and 6.7 percent for the Australian dollar — rich payouts at a time when three-month Treasuries yield 1.34 percent. To spread your bets and take advantage of the high yields, investors can keep part of their cash holdings in CurrencyShares, says Edward Lopez, director of ETF strategies for Rydex. “You can diversify your cash position by allocating some of it to a basket of foreign currencies,” says Lopez.

Investors can also bet on a basket of currencies by owning mutual funds, such as ProFunds Rising U.S. Dollar. This tracks the performance of the dollar against an index of currencies, such as euro, yen and British pound sterling. When the dollar rises, the fund delivers positive returns; if the dollar falls, the fund slips into the red. To bet against the dollar, try ProFunds Falling U.S. Dollar, which provides the inverse of the index returns. During the 12 months ending in March, the Falling Dollar fund returned 17.8 percent. Some financial advisors are putting the fund in the portion of portfolios allocated for alternative investments, says Michael Sapir, chief executive of ProFund Advisors. “This is an investment that can make money during periods when stocks or bonds are losing,” says Sapir.

Another fund that can serve as an alternative investment is PowerShares DB G10 Currency Harvest, an ETF. Following a strategy that has been popular with hedge funds, PowerShares trades the 10 major currencies. The fund starts by shorting the three currencies with the lowest yields, and then buys the three currencies with the highest yields. At the moment, the fund is shorting Japanese yen, which yield about 1 percent, and buying New Zealand dollars, which yield around 9 percent. The aim is to pick up extra yield and benefit from the tendency of investors to bid up prices of high-yielding currencies. The strategy does not work every year. But proponents argue that the approach can be an effective use of currencies, delivering returns that do not track stocks or bonds.

PLAYING THE CURRENCY GAME

Mutual funds for exposure to the currency markets.