Several ways to hedge against falling dollar

A worker at a travel agency adjusts the U.S. Dollar rate against British Sterling at the window display of a foreign currency exchange board in central London December 1, 2006. Sterling bulls eyed the $2 psychological level on Friday after the pound hit a 14-year high for a second day against a battered dollar, as the prospect of a narrowing U.S. interest rate gap continued to haunt the greenback. REUTERS/Toby Melville (BRITAIN) less A worker at a travel agency adjusts the U.S. Dollar rate against British Sterling at the window display of a foreign currency exchange board in central London December 1, 2006. Sterling bulls eyed the $2 ... more Photo: TOBY MELVILLE Photo: TOBY MELVILLE Image 1 of / 1 Caption Close Several ways to hedge against falling dollar 1 / 1 Back to Gallery

The dollar continued its slide against major world currencies last week, hitting a 14-year low against the pound and a 20-month low against the euro Thursday.

That's bad for Americans who want to travel overseas or buy imported goods but great for investors who own overseas assets.

The dollar has been declining against most major currencies since mid-2001, except for an unexpected rally in 2005. Although nobody knows where the dollar will bottom out, experts agree that currency cycles usually take many years to play out and often go to extremes before turning around.

If your portfolio has nothing but U.S. investments, it might make sense to have some exposure to non-dollar assets.

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Foreign currencies "make excellent diversifiers" because they don't correlate well with U.S. stocks and bonds, says Morningstar fund analyst Arijit Dutta.

There are many ways to gain exposure to foreign currencies, from foreign stock and bond funds to currency funds and foreign certificates of deposit. Here's a look at some, from tame to adventurous.

-- Buy currency. Of course, one way to invest in currencies is simply to go to a bank that handles foreign money and change your dollars into euros, pounds or yen. I'm not recommending this because the transaction costs are steep, the currency won't earn interest and you'll have to store it somewhere.

-- Foreign CDs. Everbank, an online bank in Jacksonville, Fla., offers CDs denominated in about 15 foreign currencies. The minimum investment is $10,000 and terms range from three to 12 months.

"Say you want to buy euros. You open an account with Everbank and give us your $10,000," says Chuck Butler, president of Everbank World Markets. "We take your dollars and convert them to euros. When the term ends, we take the whole lot of euros -- principal and accrued interest -- and covert them back into dollars at a rate that is within 1 percent of the spot rate."

That 1 percent (or less) represents Everbank's fee. You pay it each time you buy or sell a CD. If you bought currencies yourself, you'd pay considerably more.

Everbank's CD interest rates depend on the country and the term, but range from zero for Japanese yen CDs to 11.5 percent for CDs denominated in the highly volatile Icelandic krona. Euro CDs are paying 2 to 2.5 percent.

Everbank also offers foreign currency savings accounts, which offer daily liquidity and smaller minimums but don't pay interest.

Everbank deposits are insured by the Federal Deposit Insurance Corp., which would repay investors if the bank went under. But they are not insured against currency losses.

-- Foreign stock funds. When you buy foreign stocks (individually or through a fund), your return depends on what happens to the price of the stocks in their home market and what happens when those foreign profits or losses are converted back into dollars.

Suppose you are a U.S. fund manager and you buy stock in British Airways on the London Stock Exchange. To do so, you must convert dollars into British pounds. Now suppose the price of British Airways rises and you sell the stock for a profit.

When you convert your pounds back into dollars, you will have a currency gain if the dollar has fallen and a currency loss if the dollar has risen. The currency gain or loss will add to or subtract from your British Airways profit.

In recent years, many international stock funds have posted stellar returns, thanks in part to the generally weakening dollar.

Some funds try to reduce or eliminate currency risk by engaging in hedging strategies. If your fund hedges, you might have little or no foreign currency exposure. But "if you own a lot of non-hedged foreign stock funds, that may be all the exposure you need," Dutta says.

To find out if your fund is hedged, check its Web site or call customer service.

-- Foreign bond funds. Another way to gain currency exposure is to buy a fund that invests in foreign bonds. Your return will depend mainly on how much interest the bonds pay, plus or minus currency gains or losses.

Like all bond funds, foreign bond funds also are subject to interest rate risk. If interest rates go up in the countries where the fund is invested, the bonds could lose value, resulting in capital losses. If interest rates go down, the bond values could rise, resulting in capital gains.

Like stock funds, some bond funds hedge their currency risk. If you want currency exposure, buy an unhedged fund.

To see the impact of currency risk, look at the Pimco Foreign Bond fund, which comes in a hedged and unhedged version.

In 2005, when the dollar mostly rose, the hedged version gained 5.3 percent while the unhedged version lost 9.5 percent.

In 2006, with the dollar generally falling, the hedged version has gained just 3.3 percent while the unhedged version has gained 8.5 percent as of Thursday.

In the foreign-bond category, Morningstar recommends Pimco Foreign Bond Unhedged and Pimco Global Bond Unhedged and, for no-load investors, T. Rowe Price International Bond.

A note about foreign funds: For maximum overseas exposure, choose a foreign or international fund. Funds with global or world in their names sometimes invest significant stakes in the United States.

-- Hard currency funds. A hard currency fund is similar to a foreign bond fund except that it invests in short-term money market securities, which virtually eliminates interest-rate risk.

It is designed to deliver a pure play on the dollar.

The two funds in this area are Franklin Templeton Hard Currency, started in 1989, and Merk Hard Currency, launched in mid-2005.

You can think of these as foreign money market funds, with one important exception. Money market funds seek never to lose value. A hard currency fund can lose principal if the dollar soars.

The Franklin fund posted negative returns in five of the six years from 1996 through 2001 and has made money since then, including double-digit returns in 2002 and 2003. You'd never see that kind of volatility in a regular money market fund.

These funds move assets around the world in search of currencies that are undervalued against the dollar. Today, the Merk fund is invested mainly in the euro and other European currencies. It is up 12.3 percent this year as of Thursday.

The Franklin fund is invested more heavily in Asian currencies and is up 9.6 percent.

The Franklin fund is a load fund sold primarily through brokers, who receive commissions. Merk fund is no-load, but its 1.3 percent expense ratio is slightly higher than the Franklin fund's 1.2 percent.

I asked Michael Hasenstab, who manages the Franklin Hard Currency and the Templeton Global Bond Fund, which of his two funds would be better for an individual investor.

"The global bond fund is more diversified," he says. "It has investment and sub-investment grade exposure. It has short and longer maturities, although the average is fairly short right now, around 2.5 years. It has been able to generate consistent returns over the years independent of exchange rate movements. It's more of a core holding."

The hard currency fund, he says, "is more of a pure play on currencies. It has a bit more of a tactical (or short-term) element."

-- Index funds. Two fund groups that cater to speculators -- Rydex and ProFunds -- have introduced mutual funds that use derivative securities to track the U.S. dollar index. This index measures the value of the dollar against six major world currencies.

Each group has one fund that tries to replicate the index (for investors who think the dollar is going up) and one fund that matches the inverse of the index (for those who want to bet against the dollar).

The big difference is that Rydex uses leverage to deliver twice the daily performance of the index.

If the dollar index rises 1 percent in one day, the Rydex Dynamic Strengthening Dollar fund should go up 2 percent and the Rydex Dynamic Weakening Dollar index should drop 2 percent.

Because of compounding, this 2-1 ratio will not always hold up, especially if the dollar is changing direction frequently.

Rydex decided to leverage the funds because "we discovered the dollar was pretty low volatility as an asset class. We thought, if somebody wants to play currency moves, some magnification would probably be useful," says David Reilly, director of portfolio strategy with Rydex Investments.

All four of these funds premiered in 2005, so it's hard to know how they will fare over time, but they're moving in the right direction.

As of Thursday, the U.S. dollar index was down 8 percent year to date. The Rydex strengthening dollar fund was down 8 percent and the weakening dollar fund was up 12.3 percent. The tamer ProFunds Rising U.S. Dollar fund was down 5.6 percent and the ProFunds Falling U.S. Dollar fund was up 9.8 percent.

The Rydex funds can be purchased through a broker with a load or through some fund supermarkets (minimum investment $1,000) without a load. The annual expense ratio is 1.7 percent.

The no-load ProFunds require a minimum investment of $5,000. The expense ratio is 1.55 if you buy shares yourself or 2.55 percent if you go through a full-service broker or adviser.

-- Exchange-traded funds. Rydex has rolled out a lineup of exchange-traded funds that invest directly in foreign currencies. These funds trade throughout the day on the New York Stock Exchange, just like stocks.

The funds are not leveraged and should track their currencies on a roughly 1-1 basis.

The first one, which premiered a year ago, is the Rydex Currency Shares Euro Trust. It's up 14 percent year to date.

The trust buys euros, which are held in a London bank. The account earns a bit of interest, which is passed along to investors after the fund's expenses (0.4 percent a year) are taken out.

Rydex offers newer exchange traded funds denominated in Australian and Canadian dollars, British pounds, Mexican pesos, Swiss francs and Swedish krona.

Reilly says both types of Rydex currency funds are "tactical" investments designed for people who have a definite view about the dollar's direction.

"Strategic assets are stocks, bonds, real estate and commodities. If you look at their price behavior over time, they tend to trade up. From a long-term standpoint, you want to have them in your portfolio," he says.

"Currencies don't trend up like that," he says. They tend to move up for many years, then down for many years. As a result, currency funds are not designed to be a permanent part of a portfolio.