Using Foreign Funds to Correct for a Sliding Dollar

Christine Benz: Hi, I'm Christine Benz from morningstar.com. The dollar has recently slid relative to other major foreign currencies. Joining me to discuss the potential implications for investors' portfolios is Alex Bryan. He's Morningstar's director of passive strategies research in North America. Alex, thank you so much for being here.

Alex Bryan: Thank you for having me.

Benz: Alex, let's discuss why this is happening. We have seen the dollar decline relative to other foreign currencies, and lots of factors can influence that, but what are your thoughts about what's driving the dollar down?

Bryan: Yeah, so I think a big part of it is what's happening with interest rates in the U.S. right now. So the Fed aggressively cut interest rates earlier this year, in response to the coronavirus pandemic, which has really ravaged the economy and significantly increased unemployment. I think there's an expectation that interest rates will remain low for some time, particularly as the Fed strives to increase inflation expectations and boost employment. Fed Chairman Powell recently announced a shift in the Fed's monetary policy framework, where it is adopting an average inflation targeting approach. In this new framework, the Fed will allow inflation to run above its long-term 2% target following periods when it's been below that threshold before raising rates. So I think there's an expectation that interest rates will remain low for a long period of time, and that inflation might be higher in the years to come than it has been in the past. And I think both of those things can cause the dollar to continue to be weak relative to foreign currencies.

Benz: Okay. So let's discuss how this affects various asset classes. If I have equity funds in my portfolio, what are the implications of a falling dollar?

Bryan: It really depends on the company. A weak dollar should help U.S. companies that generate a larger share of their revenues outside the U.S., because that translates back into more profits in U.S. dollars. If you think about the types of U.S. companies that have more exposure to the foreign markets, they tend to be larger firms and you tend to find them more on the growth side of the style box. A lot of tech companies, consumer product companies like Apple, tend to generate more of their revenue overseas. So those types of stocks should do better in this type of environment. We would also expect some sector effects, so firms that are operating in the materials sector, industrial sector, consumer product sector, should also tend to do a little bit better from a weaker dollar, because again, they're translating their foreign revenues back to the U.S. at a more favorable rate.

Benz: And how about foreign-stock holdings? How are they affected by the dollar's decline?

Bryan: For an unhedged foreign-stock fund, the biggest effect will come directly from the currency movements where, when you own a foreign-stock fund, you effectively are owning stocks that are denominated in different currencies. So as the dollar becomes weaker, those stocks become worth more in U.S. dollars, so you actually have a direct bet against the U.S. dollar baked into unhedged foreign-stock funds. Those should actually benefit from a weaker dollar.

Benz: We've had this long running headwind for foreign-stock funds that are unhedged. It appears to have, at least in the short term, reversed a little bit.

Bryan: That's right.

Benz: Okay. So let's discuss bonds, how they're impacted by changes in the dollar's value.

Bryan: Yeah. With foreign, and I think the effect really is more on foreign-bond funds, where you see the currency impact come in, but if you look at an unhedged foreign-bond fund, most of the volatility from those funds actually comes from currency fluctuations. Effectively, an unhedged foreign-bond fund is a bet against the U.S. dollar, and that's the main driver of those returns, particularly in the short term. If you are owning one of those funds, that's unhedged, those will actually benefit quite nicely from a declining dollar.

Now, changing exchange rates also affect currency-hedged foreign-bond funds, but the effect is a bit more nuanced. Those funds, by hedging out their currency exposure, they reduce a lot of the volatility that currency fluctuations can introduce, but they're still susceptible to changes in forward exchange rates. So it doesn't eliminate the risk from currency entirely, but it certainly does smooth out the ride a bit. But I do think that investors who are looking primarily to diversify their bond holdings, and don't necessarily want to make a bet for or against the U.S. dollar, a hedged foreign-bond fund would probably make more sense.

Benz: And that's because the volatility associated with the unhedged funds is just maybe too extreme for some fixed-income investors? Or what's your thinking?

Bryan: Yeah, that's right. If you leave your foreign-currency exposure unhedged in a foreign-bond fund, you're not really getting very clean exposure to the underlying bonds, because the underlying bonds really aren't driving the returns nearly as much as the currency fluctuations are. Within foreign-bond funds, currency fluctuations account for about two thirds of the total volatility. For foreign-stock funds it's about one third of the total volatility. Again, because stocks are more volatile than bonds. But if you're looking just for that international bond exposure, and you want to get cleaner exposure to those bonds, it makes sense to take out the part of the returns that are really volatile that have nothing to do with those foreign bonds.

Benz: So how should foreign-currency fluctuations relative to the dollar, or vice versa, how should that influence how investors position their portfolios, if at all?

Bryan: I think, if you have a long enough time horizon and don't mind the volatility that comes along with currency fluctuations, there's really not a whole lot you need to do about it. I think you can just maintain a broadly diversified global portfolio and ride out those fluctuations because, over the long term, currency fluctuations tend to wash out, they tend to have very little impact on long-term returns. Now, they certainly do add to volatility in the interim. So if you are concerned about that, it might be worth considering a currency-hedged fund for your international stock and bond exposure. Again, I think that the case for currency hedging is probably stronger on the bond side, just given that the currency fluctuations are a big part of where that risk comes from. But one fund that I really like for currency-hedged exposure to foreign bonds is Vanguard Total International Bond ETF, ticker BNDX. This fund provides broad market-valuated exposure to investment-grade bonds outside the U.S., and then it uses currency forwards to hedge its currency risk. That helps tamp down on the volatility that would otherwise come from those currency fluctuations.

Benz: And how about for hedged foreign-stock exposure? Any recommendations there?

Bryan: Yeah. One fund that I really liked for hedged stock exposure is Xtrackers MSCI EAFE Hedged Equity ETF, ticker is DBEF. This fund basically targets stocks that are listed in foreign developed markets, weights them based on market capitalization, and then uses currency-forward contracts to hedge out the currency risk. So that, again, helps smooth out some of the volatility that would otherwise come from those currency fluctuations. But otherwise, it's a very broadly diversified portfolio that effectively captures the composition of foreign developed stock markets, so I think that's a really good option to consider. It is a little bit more expensive than some of the non-currency-hedged options, but it will be less risky. So, if you are more risk-averse, that might be an option worth considering.

Benz: Okay, Alex, important topic. Thank you so much for being here to share your insights.

Bryan: Thank you for having me.

Benz: Thanks for watching. I'm Christine Benz from morningstar.com.

Disclosure: Morningstar, Inc. licenses indexes to financial institutions as the tracking indexes for investable products, such as exchange-traded funds, sponsored by the financial institution. The license fee for such use is paid by the sponsoring financial institution based mainly on the total assets of the investable product. Please click here for a list of investable products that track or have tracked a Morningstar index. Neither Morningstar, Inc. nor its investment management division markets, sells, or makes any representations regarding the advisability of investing in any investable product that tracks a Morningstar index.