Playing the Weak Dollar

This article appeared on on March 1, 2004.

Investors were thrilled to see the S&P 500 notch up by 26% (plus dividends) during 2003. Sorry to put a damperon the merrymaking, but I must point out that the U.S. equity market's performance was in fact the tenth worst inthe world last year. If you parked all of your portfolio in the U.S. in 2003, you missed out.

Developed markets such as Austria, Canada and Sweden turned in performances for their local investors thatwere similar to the S&P 500's. But an American who invested in those markets would have realized gains of 50%to 60%. The same goes for emerging markets like Thailand, Argentina and Brazil. While a local investor wouldhave roughly doubled his money in any of these markets last year, an American would have chalked up gains of128% to 141%. The extra return for U.S. investors was due to the decline in value of the greenback. AnAmerican investor holding foreign stocks for a year bought, in effect, (relatively) cheap euros or reais or kronor inJanuary and sold those currencies back at higher prices in December.

That was last year. There is no assurance that owning foreign stocks will yield a currency benefit. On thecontrary. During 1997-2002, when the dollar was gaining, American investors in foreign markets did worse thanthe locals.

You have to answer two questions about foreign securities. One is whether you should own them at all. Theother is whether to hedge the currency exposure so that you get exactly the returns enjoyed by natives in theseforeign markets--no more, no less.

The answer to the first question is a resounding yes. Movements in foreign markets are less than perfectly correlated with those in the U.S.Consequently, foreign investments generate diversification benefits. As a long-term strategy, putting, say, 10% of your portfolio overseas willreduce the risk while increasing your portfolio's likely return.

The answer to the second question is more complicated. My general advice is to build an unhedged international portfolio, then make narrowlytargeted side bets against specific foreign currencies when you have reason to believe that the dollar will strengthen. At the moment I wouldrecommend skipping the currency hedges. The dollar is still weak.

Why the weak dollar? At present the Bush Administration's economic policies are perceived by most as being inconsistent, if not incoherent.Consequently, confidence in the dollar is low, and the greenback looks set to continue on its downward course. Indeed, once a currency starts totrend one way or another, it will continue to do so until it provokes a policy response. And there is not much chance of that in a presidentialelection year, unless the greenback takes a truly dramatic dive. For the short term, U.S. investors should invest in foreign stock and bond fundsthat do not hedge their foreign exchange risks.

In my last column ("The Wages of War," Dec. 8, 2003) I recommended a portfolio allocation in which 15% of the total was invested in either aU.S. index fund or an exchange-traded U.S. market basket. That should be altered so that 10% of the total portfolio is exposed to foreign stocksand bonds, leaving only 5% of the total in the U.S. stock market. And that foreign exposure should be in foreign mutual funds that do not hedgetheir exchange risks. (This adjustment bumps the total foreign exchange exposure in my recommended portfolio up to 20%, since the initialallocation to currency trading was 10%.)

Stay unhedged most of the time. Then your foreign stocks will give you diversification of both equities and currencies. The movements ofemerging market currencies, for example, tend to be inversely correlated with movements in the dollar, yen, pound and euro. Therefore, holdingunhedged positions in both developed and emerging markets will reduce your risk profile.

Does this mean that a U.S. investor who takes advantage of the diversification benefits offered up by foreign investing should never hedge theforeign exchange risk? In a word, no. The best long-term strategy is to invest in foreign funds that are unhedged. Then decide which specificcurrency risks you don't like and get rid of them. For example, if you are invested in an unhedged Swedish country fund and think the Swedishkrona is due to take a tumble against the dollar, manage that currency risk by shorting the krona against the dollar.

By investing in unhedged foreign funds and selectively managing your currency risks, you can reduce your risk in a way that a fund manager--who doesn't know the rest of your portfolio--simply can't.

Steve H. Hanke

Steve H. Hanke is a professor of applied economics at The Johns Hopkins University in Baltimore and a senior fellow at the Cato Institute.