ETFs for a Declining U.S. Dollar

Many investors anticipate that the U.S. dollar will continue to weaken. Critically, the Federal Reserve is holding short-term real interest rates below inflation. The interest rate can be thought of as the cost of money; low rates make dollars less valuable. Some emerging-markets countries, notably China, are artificially depressing their currencies in order to boost exports. Pursuing this mercantilist policy has stoked inflation in their economies. There will come a point at which the inflation becomes unbearably costly, and some market observers already see signs of inflationary stress. A sure way these countries can ease inflationary pressures is to allow their currencies to appreciate, which would further weaken the dollar.

A currency is essentially a short-term IOU, and to the extent that foreign governments hold them in reserve indefinitely, those are debts that the United States issued and for which it received goods that it never has to pay back. That free ride may be coming to an end. As pointed out by fund manager Axel Merk, China has been shedding its massive U.S. Treasury holdings. The country, which is slowly opening up its currency to foreign markets, has even called to replace the dollar as the reserve currency with a super-sovereign currency similar to the Special Drawing Right issued by the International Monetary Fund. John Lipsky, acting Managing Director of the IMF, suggested in a recent speech that the yuan will become a candidate for inclusion in the SDR basket. If the U.S. doesn't get its fiscal house in order, the death of the dollar's reserve-currency status may come to pass, which would further push down the dollar.

Despite widespread expectations for a weakening dollar in the long term, we don't think dramatic portfolio shifts or direct foreign-currency holdings are called for. It's devilishly hard to time currency movements. Compound the difficulty of timing the market is its zero-sum nature: The only way to make money in currencies is to take money from someone on the opposite side of one's trades. Currencies also have very weak long-term returns; they're still cash and over the long term will most likely struggle to keep up with inflation. For these reasons, we don't recommend long-term allocations in currency exchange-traded funds such as  PowerShares DB US Dollar Index Bearish (UDN) or  CurrencyShares Euro Trust (FXE). While these are great ways to speculate or hedge against the dollar, they will not provide stellar returns for a long-term investor. With these caveats in mind, we recommend the following ETFs for investors seeking to diversify their dollar exposure.

 WisdomTree Emerging Markets Local Debt (ELD) invests in medium-term sovereign bonds of emerging-markets countries. The fund invests in up to 14 countries and uses a somewhat active strategy to give higher weights to countries that maintain better fiscal discipline. Currently, Indonesia, Brazil, Mexico, and Malaysia are at the highest weight of 11% each. Bill Gross is a notable proponent of foreign-currency exposure.

 Vanguard FTSE All-World ex-US ETF (VEU) charges just 0.22% and makes a great core international-equity holding. It includes virtually the entire investable world outside of the U.S., including both developed- and emerging-markets countries and utilizes a market-cap-weighting approach, which helps keep turnover to a minimum.

 SPDR DB Intl Govt Infl-Protected Bond (WIP) benefits from both foreign-currency exposure and inflation protection, as it invests in the international equivalents of Treasury Inflation Protected Securities. The fund has about an 18% weight in U.K. bonds and 17% in France. Canada, Turkey, Germany, Sweden, Italy, Japan, Israel, and Brazil each make up about 5%.

 WisdomTree Emerging Markets SmallCap Dividend (DGS) should correlate more closely to emerging-markets economies than do the global conglomerates that dominate the emerging markets. Additionally, the focus on dividend-paying stocks tilts the fund toward higher-quality companies that are able to pay out a portion of their profit to shareholders. However, the 0.63% expense ratio is rather high by ETF standards.

 IShares S&P Global Materials (MXI) is an indirect play on commodities, with the expectation of a positive long-run return. One purpose of money is to serve as a store of value, but this can be eroded by inflation. Investors seeking to maintain value often look to commodities. There are even funds such as  WisdomTree Dreyfus Commodity Currency  that seek out currencies of commodity-exporting nations. However, like currencies, commodities themselves are not productive assets. On the other hand, MXI invests in stocks of commodities producers. Not only do these companies typically own commodities, but they can add value by refining or discovering more.

We caution that markets tend to price in information that everyone knows. There's also well-reasoned disagreement over the future direction of the dollar. Richard Bernstein, the former investment strategist at Merrill Lynch, is making the opposite call. He has predicted that in 2011, the U.S. dollar will strengthen and U.S. small caps will outperform. But given the market forces bearing down on the dollar, we think diversifying away from the dollar is a good insurance policy.

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