The Best Ways to Broaden Your Currency Holdings

There must be a new sheriff in currency-town, and it's not the dollar.

That, in a nutshell, seems to be the general consensus among financial gurus these days. In fact, talk of the dollar losing its status as the world's reserve currency (that is, the currency most often used in foreign trade) has faded in and out for a number of years now, prompted in part by the creation of the euro in 1999. The greenback started to decline in 2002, losing 33% against the euro by the end of 2004. Then, just when it seemed that further decline was inevitable, the dollar surged in 2005, gaining about 15% against the euro and the Japanese yen. This year, however, the dollar has sagged again, losing 7% versus the euro but holding its own against the yen, as prominent investors like Warren Buffett and PIMCO's Bill Gross are again voicing concerns about the dollar.

What's Ailing the Dollar?
No doubt, there are valid factors weighing on the greenback right now. In total, Americans (including private citizens, corporations, and various arms of government) have been spending more than they earn. As a result, the United States has large budget and trade deficits (the difference between the nation's exports and imports). The annual budget deficit was almost $300 billion last year (compared with a $200 billion surplus in 2000), and the nation's trade deficit has accumulated to more than $700 billion in 2006 (up from less than $100 billion in 1996).

Foreigners (central banks and private investors) have financed this deficit through their purchases of U.S. assets, mainly Treasury bonds. Such investors may reach saturation at some point and decide to put their savings elsewhere, which means the dollar (which is needed to buy U.S. assets) would then be less in demand and would therefore slide against other currencies. It's also worth noting that U.S. authorities have some incentive to see the dollar decline because a cheaper dollar would make American exports more attractive, which in turn would reduce the trade deficit. Thus, most signposts point to a lower dollar in the future.

What Should Investors Do?
Before you bet the ranch on financial instruments that stand to benefit from a lower dollar, bear in mind that currency markets often defy all macroeconomic logic. The dollar climbed against the odds in 2005 as foreign investors chased higher U.S. yields, and prominent foreign countries such as China can also affect currency markets through direct intervention. (Just as U.S. policymakers might want to see the dollar fall because it makes U.S. goods cheaper overseas, it is in the interest of Chinese exporters not to let the Chinese currency rise too much.) Thus, even Warren Buffett has unwound his direct currency bets against the dollar and chosen to buy more foreign companies instead. And at PIMCO, for all his warnings about the dollar, Bill Gross doesn't advocate the firm's direct currency bet against the dollar to exceed 5% of total assets. (That is, in PIMCO's foreign-bond portfolios, the active currency bets against the dollar aren't likely to exceed 5% of assets.)

Because currency movements are notoriously hard to predict, we would also advise that investors avoid big bets on the direction of the dollar. Yet we also think it's advisable to have at least a small amount of nondollar currency exposure in your portfolio. You can look at it as buying some insurance against the possibility of a sharp decline in the dollar. In the long run, foreign-currency exposure also tends to diversify a portfolio nicely. Here are some of the best vehicles for playing foreign-currency markets.

Good Old Foreign-Stock Funds
Before you add nondollar exposure to your portfolio, take a moment to gauge how much exposure to foreign currencies you already have. If you own foreign-stock funds that are unhedged (meaning their securities are denominated in foreign currencies), you own a similar percentage of nondollar exposure. True, unhedged foreign-stock funds are an imperfect way to protect a portfolio from a dollar decline. For example, a weak dollar may hurt foreign companies that depend on exports by making their products more expensive for U.S. consumers. Thus, foreign-stock funds add a lot of stock-specific complications to their currency exposure. That said, if you have substantial exposure to a wide range of foreign equities (including smaller-cap stocks, which tend to be less dependent on exports), then you probably already have pretty decent protection against a falling dollar.

Foreign-Bond Funds
Because currency movements are a fairly large percentage of international-bond funds' returns, such offerings are a more direct way to play a falling dollar than are foreign-stock funds. While security selection will play a role in a bond fund's overall performance, returns generally fall in a narrower range for bonds than stocks, so for bond funds, large currency swings tend to dominate gains or losses from security selection. But if you venture into an international-bond fund in search of nondollar exposure, make sure you pick a fund that's committed to remain unhedged at all times. (Some funds hedge--or don't--at management's discretion.) In addition, expect unhedged portfolios to be significantly more volatile than hedged offerings.

 PIMCO Foreign Bond (Unhedged) (PFUIX) and T. Rowe Price International Bond (RPIBX) are two of our favorite unhedged funds. The PIMCO fund benefits from the firm's vast research capabilities as well as management's risk-averse stance. T. Rowe Price International Bond is somewhat more adventurous as it is willing to go further afield into areas such as emerging markets, but management is experienced and price-conscious. The truly adventurous might also look at Templeton Global Bond (TPINX). Management will make significant direct currency bets, including those on especially volatile emerging-markets currencies.

Currency Funds
Currency funds provide the most direct means to profit from a falling dollar, but most of these options are risky, expensive, gimmicky funds that launched within the past year or so. For example, ProFunds Falling U.S. Dollar (FDPIX) seeks to mimic the gains posted by an index of developed-market foreign currencies through the use of complex derivative securities. The fund's record is only a few months long, but it is likely to be a rather volatile choice, and it costs almost 4 times as much as PIMCO's unhedged foreign fund. ProFunds also has a "Rising Dollar" fund for those who'd rather swim against the current tide.

 Franklin Templeton Hard Currency , which has been around since 1989, may be a more viable choice. That fund invests directly in a variety of foreign currencies mostly through money-market securities in developed countries, though it will also indulge in emerging-markets currencies with strong fundamentals. It's been around for more than a decade, and the same management team as at the aforementioned Templeton fund holds charge here.

Other Options
You can always play currency markets directly, by owning currencies or derivatives securities based on them, but that's obviously a complicated route. The other option is to invest in precious metals like gold and silver, which some view as a better store of value than currencies. We'd advise caution for investors venturing into precious metals at this time, however, particularly when you consider the enormous runup the sector has had over the past five years.

Overall, we would think carefully before venturing into currency markets. Rather than engage in currency speculation, investors should approach the decision about whether and how to obtain currency exposure more from a diversification and risk-control angle. Numerous factors can affect currency markets, and this makes it extremely hard to bet correctly on them. Broad exposure to nondollar assets may be the best option.