The Right (and Wrong) Way
To Protect Yourself Against
The Falling Dollar
December 1, 2004

What if the buck doesn't stop here?

Investors are shoveling money into foreign-stock and bond mutual funds, hoping to profit from the tumbling dollar. I fear, however, that many of these folks will be a tad disappointed.

According to the Investment Company Institute in Washington, foreign-bond funds have attracted $3.8 billion from investors so far this year, up 61% from the same stretch in 2003, while foreign-stock funds have pulled in $50.6 billion, a staggering 213% increase.

Clearly, a lot of foreign funds are garnering a heap of money -- but not all of them will soar if the dollar keeps sinking. In fact, only small-company foreign-stock funds and international-bond funds give you anything close to a pure currency play. And because they hedge their currency exposure, some of these funds may get scant benefit from a falling dollar.

BUCKING THE DOLLAR Looking for funds that will gain from a tumbling dollar? Check out these no-load funds.   Annual expenses 2004 Return* American Century Int'l Bond 0.87% 10.60% Fidelity Int'l Small Cap 1.30 23.8 Looms Sayles Global Bond 1.00 8.1 T. Rowe Price Int'l Bond 0.88 9.5 Third Avenue Int'l Value 1.75 25.2 Through Nov. 29, 2004 Source: Morningstar Inc.

Risky business. Lately, there has been a flurry of articles arguing that now that the dollar has fallen steeply, it's time to invest abroad. I am always amused by such belated enthusiasm. Wouldn't it have been smarter to have ventured overseas before the dollar started hitting new lows?

"You have two things that are red-hot right now," says Larry Swedroe, research director at Buckingham Asset Management in St. Louis. "One of them is commodities and the other is international funds. Investors chase yesterday's returns. But you can't buy yesterday's returns. What matters is the future."

On that score, I suspect the dollar will continue to slide. But I wouldn't buy a foreign stock or bond fund based on that hunch. Instead, as you add foreign funds to your investment mix, think of these holdings as portfolio insurance. Suppose the dollar's decline snowballs, prompting investors to bail out of U.S. stocks and bonds. In that scenario, your U.S. stock and bond funds would get hammered, but foreign funds may ride to the rescue.

I typically suggest that investors stash up to 30% of their stocks and up to 15% of their bonds in foreign funds. Which funds should you buy? There are five major categories to consider.

To get exposure to developed markets like Germany, Japan and the United Kingdom, you could buy a large-company foreign-stock fund, a small-company stock fund and an international-bond fund. Meanwhile, to tap into developing markets, you might purchase an emerging-market stock fund and an emerging-market debt fund.

All five funds are useful components of a well-rounded portfolio. But they aren't all equally attractive if you are looking to diversify out of the dollar. For instance, large-company stocks in Europe and Japan tend to rise and fall along with large-capitalization U.S. stocks.

These large multinationals "are all in the same markets and they're all going after the same customers," notes Nelson Lam, an investment adviser in Lake Oswego, Ore. "They just happen to have their headquarters in different places."

Indeed, while a falling dollar makes large-cap foreign stocks more valuable for U.S. shareholders, the dollar's slide also hurts these companies by making their exports to the U.S. less profitable.

Similarly, emerging-market stock and bond funds probably won't be big winners if the dollar continues to slip. Why not? Not only do many emerging markets peg their currencies to the greenback, but also much of their debt is denominated in dollars. As Mr. Lam puts it, "you should buy these funds more for their performance than their diversification benefit."

Gaining currency. Instead, if your goal is to hedge against a tumbling dollar, Mr. Lam advises investing in funds that focus on either bonds or small-company stocks from developed foreign markets.

Historically, there's been a low correlation between the U.S. market and foreign small-cap stocks. One possible explanation: Unlike large-cap foreign stocks, these smaller companies typically aren't big exporters to the U.S. and thus don't face the same profit squeeze when the dollar tumbles.

Prefer bonds? "The purest play on a dollar decline would be a foreign-bond fund," says Jeremy DeGroot, research director at Litman/Gregory Asset Management in Orinda, Calif. He notes that the yields on high-quality U.S. and foreign bonds are similar. "Even if the dollar doesn't decline, there's not a big opportunity cost to owning a foreign-bond fund," Mr. DeGroot argues.

And if the dollar does spiral lower, holding a foreign-bond fund could salvage your portfolio's performance. "It's a nice piece of insurance," Mr. DeGroot says.

Unfortunately, while foreign bonds and small-cap stocks are great ways to diversify, there aren't great low-cost investment choices for ordinary investors. Among foreign small-cap funds, Mr. Lam suggests Fidelity International Small Cap and Third Avenue International Value. Meanwhile, for international-bond exposure, he likes American Century International Bond, Loomis Sayles Global Bond and T. Rowe Price International Bond.

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