Be Careful If Trying to Bet on Dollar's Rise

It's a scary time in the market. Not only are stocks falling--and falling--but most bonds have had a rough go as well. Commodity prices are plunging, too. But there's a bright spot--after years of decline, the dollar is rising.

Quickly, in fact. Just a few months ago it cost more than $2.00 to get a pound's worth of ... well, whatever costs a pound in London. Now that's down to $1.59. The Australian dollar, which has climbed almost to parity with the greenback, now fetches just U.S. $0.62. It's the same story for just about every currency except Japan's yen, which has enjoyed a powerful surge of its own.

A stronger dollar seems like a good thing. It sounds macho. Who wants their country to have a "weak" currency? But the dollar's ascent doesn't bring unalloyed benefits. It makes life harder for U.S. exporters selling goods and services abroad. And it doesn't do any favors to Americans who own internationally focused mutual funds.

For years, those shareholders have benefited as foreign currencies gained against the dollar. When foreign currencies rise, shareholders get a bonus because the fund is buying and selling in those foreign currencies. If the euro or pound or peso is worth 10% more when the fund sells a stock than when it bought it, the fund's return gets a nice boost.

With the winds having changed direction, though, plenty of U.S. investors are wondering if they should dump their unhedged foreign funds. (The vast majority of international-stock funds are unhedged, that is, fully exposed to foreign-currency fluctuations.) With everything else seemingly falling apart, why not get on the right side of at least one wave? As Karin Anderson wrote in a Fund Spy column this August, few foreign-stock funds have policies of hedging most currency exposure into the dollar. But three do have substantial hedges in place all the time:  Longleaf Partners International (LLINX),  Mutual European (MEURX), and  Tweedy, Browne Global Value (TBGVX). Not surprisingly, all three are beating the bulk of their respective categories for the year to date (the latter two are in the top decile), even though all have suffered steep losses in the stock meltdown.

Not So Simple
However, buying one of those funds simply in an attempt to profit from an expected continuation of the dollar's rally wouldn't make sense. One reason is that currency moves are notoriously hard to predict: Just because the dollar has been rising doesn't mean that it will keep rising. But even if you're convinced that it will, remember that these are stock funds. Their returns depend on the performance of the stocks in their portfolios as much as--or more than--they depend on the performance of the currencies. That's why the funds are down so much this year even though they've reaped the benefit of dollar strength. Mutual European has lost 33% this year--and that's the best performance of the three. The Longleaf fund had one of the better showings in its group last year, even though the currency trends were working against it as the dollar sagged.

Meanwhile, these funds in particular require shareholders to be comfortable with their specific style. They're certainly not generic foreign-stock plays or currency bets. All have iconoclastic strategies and all lean heavily toward the value end of the spectrum, so their portfolios don't look one bit like the indexes. Moreover, the Longleaf and Tweedy, Browne funds aren't even pure-foreign--they typically own some U.S.-based stocks as well. And all three often don't hedge the entire portfolio. We have respect for all three funds, but if you buy them, do so because you like their investment strategy as a whole--and understand how their currency stance will and won't affect performance--not as dollar plays.

Many other funds, such as  Oakmark International (OAKIX), have been partly hedging their foreign-currency exposure over the past couple of years as their managers became convinced that the dollar was undervalued. Good for them. But because these hedges are partial and could come off at any time, these funds are even less appropriate for dollar bettors than the three named above.

If You Must Indulge
Therefore, if you do think that the dollar is in for a long rise, and you're intent on trying to take advantage, more-direct methods are preferable. Those might include a foreign-bond fund that's fully hedged into the dollar by mandate. Bonds--especially government bonds--react more closely to currency moves than stocks do, because the factors that influence bond prices tend to affect currencies as well (and the typically smaller range of absolute returns on bond funds versus stock funds can magnify the effect of currency gains and losses on a bond fund's overall performance).

However, it's important to recognize that a bond fund is still an indirect play. After all, bonds, like stocks, do react to forces that may have little to do with currency movements. For example, a solid choice among hedged bond funds,  PIMCO Foreign Bond (USD-Hedged) , is saddled with a 4.9% loss for the year to date through Oct. 24 despite the stunning rise in the dollar.

Thus, the most direct way to place a dollar bet is on the dollar itself. These days, that's much easier for a retail investor to do than it was just a few years ago. At one time, one almost had no choice but to use complicated derivative strategies. Now there are numerous mutual funds and exchange-traded funds that allow you to make just about any currency play that you want.

That's not a recommendation to take that route. You can also simply own a broad array of domestic and international funds, some exposed to foreign currency movements, and just let the long-term effects cancel each other out, as they tend to do in many ways. That's easier than trying to guess the direction of currency shifts--and to predict when that direction will change. The critical point, though, is that if you do want to place a pure-currency bet, don't expect a stock fund to fill that role.