Betting Against the Buck

Many experts predict that the value of the U.S. dollar will continue to drop. At the end of the third quarter of 2003, the U.S. dollar had lost 10 percent of its value on world markets in 12 months; during the same period, the Japanese yen had gained 10 percent and the euro was up by 20 percent. Several current reasons have been given for the drooping dollar, from falling short-term U.S. interest rates to a bulging current account deficit, but there also may be longer-term issues to consider. Currencies tend to move in cycles:

• From 1971 through 1978, the dollar declined.
• The dollar appreciated for the next seven to eight years.
• Then the dollar fell back from 1986 to 1993.
• In the late 1990s the dollar was strong.
• However, the dollar has weakened recently and may continue to drop in the next few years.

An ongoing descent in the value of the dollar would increase the value of profits reported in yen, euros, etc. Thus, a weaker dollar would increase returns from investments denominated in other currencies.

You can participate in possible currency gains (while bearing the risk of loss) by buying American Depositary Receipts (ADRs), issued by thousands of foreign companies. This may be the best way for small investors to invest abroad because you’ll know what you own and it’s easy to find information about various companies. You may fell comfortable holding the ADRs of well-known foreign companies.

The same exposure to a widely-anticipated drop in the dollar may be available through mutual funds holding foreign stocks. Most international funds have the right to hedge currencies but, in practice, they don’t. Thus, unhedged funds can pass through currency gains or losses to domestic investors.

Putting together a varied combination of foreign funds may have gotten easier. In October, Morningstar Inc., Chicago, divided its former “foreign stock” category into five smaller categories: three large-cap groups (value, growth, blend); another for small- to mid-cap value funds; and one for small- to mid-cap growth. Most foreign large-company funds have minimal if any exposure to small companies so there’s little reason to worry about portfolio overlap if you buy a foreign small-cap fund as a supplemental holding.

Another possible approach is to start with a large-cap foreign fund, as a core holding, and then add an emerging markets fund as a diversifier. Alternatively, you can buy an Asian fund as a supplement, if you think that area of the world offers the best opportunities.