What to Do About Foreign Currency Exposure

The dollar has taken a wild roller coaster ride over the past three years, wreaking havoc on a portion of many investors' portfolios. If you're wondering what to do about that, you aren't alone.

"Everyone is talking about this. Clients are getting concerned," says Tyler Vernon, chief investment officer of Biltmore Capital Advisors in Princeton, N.J.

Strategies to deal with the dollar's fluctuation range from avoiding any foreign currency exposure to eagerly seeking it. Such exposure can help diversify your portfolio and enable you to benefit from a weaker dollar.

You can even speculate on the direction of currencies using exchange-traded funds, or ETFs, options or futures. But many financial advisers recommend against such activity, because the risks of speculation can be high.

Not for Novices

"Most people don't have the ability to analyze or anticipate these kinds of currency moves," says Charles Lieberman, chief investment officer at Advisors Capital Management in Hasbrouck Heights, N.J. "That's really a professional's market, and professionals often get it wrong. It's not something most individuals should be doing."

He says you may want to avoid straying from the dollar at all. "We earn our compensation in dollars and spend our income in dollars. When you go into other currencies, it entails complications and costs that are significant."

If you desire to tap into economic growth overseas, you can simply invest in blue-chip U.S. companies that generate a lot of their revenue there, Lieberman says.

Others are more adamant about the need for currency diversification. "If you're a dollar-based investor, it's worthwhile to have exposure outside of the dollar," says Kevin McDevitt, a mutual fund analyst for Morningstar research firm in Chicago.

Given the dollar's weakness in recent years and the strong possibility that the Federal Reserve will maintain an accommodative monetary policy, "it's a good idea to look for ways to diversify out of the dollar," he says.

To Hedge or Not to Hedge?

The main currency question for most individual investors is whether to buy international stock and bond funds that hedge their foreign currency exposure. The managers of these funds often purchase their foreign stocks and bonds with the issuers' home currencies.

But your fund shares are priced in dollars and any dividends and interest income are paid to you in dollars, of course. So the fund must translate its holdings from their native currencies into dollars. When foreign currencies rise and the dollar falls, that will boost the dollar value of fund shares and dividends or interest payments.

Conversely, when foreign currencies fall and the dollar rises, that will depress the value of fund shares and dividends or interest payments.

Hedging strategies, generally involving futures and options, allow fund managers to avoid any impact from currency fluctuation. Therefore, share and dividend-interest payment values won't be affected whether the dollar goes up or down.

If you want to take currencies out of the equation, you'll want to purchase funds that hedge, though you probably will have to endure higher fees to pay for the hedging strategy.

But if you want exposure to foreign currencies, which will help you when the dollar falls and hurt you when it rises, then you'll want an unhedged fund.

'Waste of Money'

David Cowles, director of investments for Mosaic Financial Partners in San Francisco, recommends against hedging. "We like a diversified portfolio to hold U.S. and foreign assets," he says. "But in the long run, we think currency movements are a wash. It does reduce volatility, but there is a cost. We think it's a waste of money."

If you have a strong view on the dollar or another currency's direction, there are several ways to put your money behind your view. Perhaps the easiest and safest are currency ETFs. Conventional wisdom has it that emerging market currencies will gain against the dollar in coming years, says Michael Sheldon, chief market strategist at RDM Financial Group in Westport, Conn.

If you want to speculate on that view, you can invest in a Chinese yuan, Indian rupee or Brazilian real ETF, for example. The fund's value will rise if the currency does, and you will receive income based on the country's money market rates. But beware: Conventional wisdom can often be wrong.

More sophisticated hedging can involve futures, options, managed futures funds and structured products. But most of these strategies are complicated and can incur substantial costs.

"For the average investor, getting involved in currency markets is probably way too complicated and not worth the hassle," Sheldon says.