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Play the dollar's drop with overseas funds
Foreign bond, exchange-traded and closed-end funds all offer ways to take advantage of the dollar's decline. But go gingerly into this market.
By Timothy Middleton
One immediate consequence of the presidential election was a weaker dollar, which the Bush administration is using, sotto voce, to attack the nation's soaring trade deficit. Within days of the election, the dollar fell to a historic low against the euro.
Mutual fund investors can't play currencies directly; there's no "Weaker Dollar Fund." But a number of funds at least tilt in that direction. I noted this in my column last week on foreign small-cap funds, which have been the top diversified fund performers this year in part because of the currency kick they've gotten as foreign currencies appreciate.
And there are two other options for those who want to profit from the greenback's wilt. The clearest winners are foreign bond funds, because their credit-savvy managers are especially qualified to judge currencies. Close behind are unhedged country funds, notably exchange-traded and closed-end funds. (Hedging currencies involves transactions aimed at minimizing the effect of fluctuations in their values, which you don't want if you're trying to benefit from the moves.)
A relative appreciation
"From a big-picture standpoint, the way you benefit is from currency translation back into the U.S. dollar," says Tim Woolston, portfolio manager with Boston Advisors, a private money manager. "Basically you're looking at investing in a country where you expect the currency to appreciate relative to the dollar."
That means Europe and, especially, Asia, where the dollar's weakness hasn't been felt yet because of the stiff defense of the Chinese yuan and the Japanese yen. If the Chinese currency is unlinked from the greenback and Japan eases its massive intervention to prop up the yen, as seems increasingly likely, currency profits could flood from the region like water through a broken dam.
Speaking to an investment conference in Tokyo last week, Morgan Stanley chief economist Stephen Roach said, "The dollar has got a good deal further to go on the downside."
Turning to the experts
Foreign bond funds: These portfolios are even more likely than equity funds to offer currency gains. Fixed-income managers are credit experts, and credit conditions fluctuate with interest rates and the other economic trends that underlie currency strength.
"Typically they are more comfortable making currency bets," says Morningstar analyst Gareth Lyons. One fund that Morningstar rates an "analyst pick" is T. Rowe Price International Bond (RPIBX), which doesn't hedge currencies, and in the three years ended Sept. 30 raked in annualized gains of 12.1%, the bulk of them from the dollar's decline.
Related commentary on MSN Money
This fund "offers a level of diversification that is difficult to match" because of its unusually heavy reliance on currency gains, says Lynn Russell, another Morningstar analyst. "The fund's returns are largely driven by the fortunes of the dollar."
The ETF option
Exchange-traded funds: These are index funds that include both country and regional portfolios. "We do not hedge currencies in any of our ETFs," says a spokesman for Barclays Global Investors, the largest sponsor of exchange-traded funds. (ETFs trade like stocks.)
One that I use in the model ETF portfolio I maintain is iShares MSCI EMU Index Fund (EZU, news, msgs), whose benchmark is a measure of markets linked to the European Monetary Union; i.e., the euro zone. The fund is up 10.9% this year, as of Nov. 10, despite weak European economies, because of the euro's strength. By comparison, S&P 500 Spiders (SPY, news, msgs), the ETF that tracks the S&P 500, was up 6.3% in the same period.
Barclays also has a number of Asian ETFs, including iShares FTSE/Xinhua China 25 Index Fund (FXI, news, msgs). This fund mainly owns stocks that are priced in Hong Kong dollars and traded on that island's exchange, so potential currency appreciation is only indirect. The Hong Kong dollar is pegged to the greenback independently of the Chinese yuan.
A fertile region
Closed-end funds: The most fertile area for these portfolios, which trade like stocks but, unlike ETFs, are subject to wide discounts and premiums in their market prices, is Asia.
"China would be a prospect, and Japan because it's benefiting from proximity to China," says Woolston.
Most closed ends specialize in Asia but exclude Japan because that mature market is so unlike the developing nations around it. An exception is Morgan Stanley Asia Pacific Fund (APF, news, msgs), which has half its assets in Japan and the balance spread from South Korea to Australia.
As of Oct. 31, the fund was up 7% this year, after a surge of 51.9% last year. But its share price of $12 on Nov. 10 was well below its net asset value of $13.44, creating a discount of 10.7%.
Playing the discount
That's probably because investors are disgusted Japan has refused to allow the yen to appreciate, although discounts are chronic among closed ends and this one is near its historic average. But a change in sentiment could see the discount narrow, providing an extra profit punch.
Long-term investors should ignore this whole matter because over long periods, currency translations roughly equal out. "Actively playing currencies is a dangerous thing," warns Morningstar's Lyons, "and a lot of portfolio managers have realized that, too. It used to be quite popular, but not now."
So my advice is to go gingerly into this arena. The income I derive from a weak dollar is mainly psychic, in the flavor called Schadenfreude: Watching anti-American Europeans writhe as their creaking economies groan under the weight of an uncompetitive currency.
At the time of publication, Timothy Middleton didn't own any securities mentioned in this article.
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