How a Falling Dollar Affects Your Portfolio

Trying to predict the direction of the dollar--or the trajectory of any foreign currency--is a tricky business. Not only do you have to get your arms around the future of the U.S. economy and interest rates, but you also have to think about the U.S.' prospects relative to overseas markets. Government policy--including central bank action (interest-rate policy) and deficits--are in the mix, as is investor sentiment.

Market shocks can affect how currencies behave, too. Immediately after the 9/11 terrorist attacks, for example, the dollar plummeted relative to major foreign currencies. The key question on the docket: Will investors prefer U.S.-dollar-denominated assets in the future, or assets denominated in foreign currencies?

If those questions have you drawing a "shruggie" (¯\_(ツ)_/¯) you're not alone. In fact, the difficulty of predicting currency movements helps explain why most professional investors don't try to profit from them, and those that do haven't always made a compelling case for the practice.

Take Templeton Global Currency Fund ICPHX, the oldest currency-specific mutual fund in existence. While the fund has indeed behaved differently than plain-vanilla dollar-denominated stocks and bonds, and boasts veteran managers in Michael Hasenstab and Sonal Desai, it doesn't compel on a standalone basis. Owing largely to the fund's mandate to maintain a short position in the U.S. dollar, which has enjoyed bursts of strength since the financial crisis, the fund's 15-year returns have been lower than the average short-term bond fund's. Meanwhile, volatility, as measured by standard deviation, has been three times as high over that stretch.

I've argued that individual investors shouldn't monkey around with currency forecasting, either, notwithstanding the bumper crop of exchange-traded products designed to capitalize on the direction of the dollar and other foreign currencies. In my view, predicting currency movements as an investment activity unto itself--versus obtaining foreign currency exposure indirectly via investing in foreign-currency-denominated stocks or bonds--belongs in what Warren Buffett has called the "too hard pile."

But even if investors aren't actively trading currencies themselves, foreign-currency fluctuations can have implications for their portfolios and the way they behave. That's true whether the dollar is declining, as it has been recently, or appreciating, as it did for a healthy chunk of the past five years. Currency effects also have implications for investors with direct exposure to foreign currencies--either nondollar-denominated individual securities or mutual funds that hold them--as well as investors with holdings in U.S. companies that happen to have exposure to foreign markets.

Effects on the Businesses Themselves

For U.S. investors who own stock of companies that sell stuff overseas--either directly or through mutual funds--a declining dollar will tend to benefit such holdings by making their goods or services cheaper to overseas buyers. Thus, the dollar's recent decline is generally construed as good news for U.S. companies that derive a big share of their revenues from foreign sales, such as

As you'd expect, the dollar's decline can have the opposite effect on foreign companies' businesses. Because a declining dollar makes imported U.S. goods cheaper and more attractive, foreign companies competing with U.S. companies in overseas markets may need to lower their prices to stay competitive, which has the potential to dig into their profits. On the other hand, foreign companies relying on U.S. imports to make their goods will tend to benefit when their currencies gain and the dollar falls; their input costs go down because they don't need as many euros, yen, or other currencies to buy what they need in the U.S.

Effects for Foreign Stock Investors In addition to the repercussions of a declining dollar for U.S. and overseas businesses themselves, U.S. investors in foreign-currency-denominated securities may also see effects from a declining dollar, both positive and negative.

That's because a foreign-stock investor's return consists of two parts: any gain or loss in the security itself over their holding period, as well as any gain or loss in the currency in which it's denominated over the same time frame. If a foreign stock gains 15% but the currency in which it is denominated loses 25%, the investor will have a 10% loss. That helps explain why many foreign-stock fund investors saw their holdings disappoint relative to U.S. stock holdings in the period from 2011-2016: Foreign stock markets performed reasonably well, but those gains lost some of their oomph when foreign currencies' declines relative to the strong dollar were factored in. Not surprisingly, foreign-stock funds that hedge their currency exposure--that is, employ futures contracts to remove gains or losses in foreign currencies from their returns--performed much better than their nonhedged counterparts (spurring a boomlet in the launch of hedged ETF products) over that time frame.

When the dollar declines and foreign currencies gain, as has been the case recently, the opposite occurs. Holders of foreign stocks that are denominated in local currencies have the potential to benefit from gains in the securities themselves, as well as gains in the currencies. That helps explain why hedged foreign stock funds and ETFs delivered lackluster gains in 2017 and have done so in 2018's early innings, too. Since the beginning of 2017, the unhedged version of the

Effects for Investors in Foreign Bonds

The good news for foreign stock investors is that currency movements tend to be much less extreme than stock-price movements, so currency fluctuations, whether good or bad, represent a fairly small part of the return equation for investors in equities. It's a different story for investors in foreign bonds denominated in foreign currencies, however. High-quality bond-price movements are much more muted, on average, than stock prices, so currency fluctuations represent a much larger percentage of the returns that investors in foreign-currency-denominated bonds experience. That helps explain why unhedged foreign bond funds--that is, bond funds that are fully exposed to currency fluctuations--are substantially more volatile than bond funds that hedge their foreign currency exposure. On the other hand, a hedged foreign bond fund's performance is explained by changes in the value of their holdings, not foreign-currency changes. For example, PIMCO Global Bond (Unhedged) PIGLX has a 15-year standard deviation—a measure of volatility—that’s nearly twice that of

The net effect of a declining dollar on investors in international bonds, then, depends on the hedging status of the investment. When foreign currencies gain in value relative to the dollar, as has been the case recently, that will enhance the unhedged investor's return. On the other hand, the investor in the hedged international-bond product will not benefit from foreign currencies' ascent. For example, the unhedged version of PIMCO Global Bond has returned twice that of the hedged version over the past year. Understanding a global bond fund's hedging status is crucial to knowing what to expect and how it fits into your portfolio. Hedged international bond funds offer modest volatility and performance that is generally more bondlike, whereas unhedged foreign bond funds offer better diversification with substantially more volatility.

Investors in core intermediate-term bond funds should also be aware that their funds may dabble in foreign bonds, and that can affect their performance, for better or for worse. If a core bond fund has meaningful exposure to overseas bonds, Morningstar analysts will typically call attention to it in their reports, and investors can also see a fund's foreign-bond exposure on a fund's Portfolio tab on Morningstar.com. The presence of foreign bonds isn't inherently a red flag, as such bonds typically compose less than 15% of a portfolio, but knowing how a fund is positioned can help explain performance.