Currency speculators beware
Why it's tough to guess the direction of the dollar, euro, or yen
I received e-mails like this one steadily throughout 2009, as bad news regarding the deficit and the US economy cast a dark shadow over the greenback's prospects.
Everywhere I went, it seemed, people were accepting as gospel a doomsday scenario for US investors during the next decade and beyond: higher taxes, higher inflation, and a weaker dollar. A user posted a comment on Morningstar.com in late 2009 saying that his bearish dollar view was simply a reflection of "a new monetary reality."
But within the past few weeks, I've noticed something interesting. I'm still receiving messages about currency fluctuations and how to profit from them, but investors are no longer asking about how to bet against the dollar. Instead, they're asking how to bet on it, and against the euro. On Friday, I received a question about international funds that began, "If one believes the dollar will be strengthening in the next five years…,"
The change in sentiment regarding the dollar's fortune shouldn't surprise anyone. Foreign-currency fluctuations are notoriously mercurial, driven by factors as diverse as economic growth, deficits, and interest rates. Just when all of these point to a currency heading in one direction or another--as seemed to be the case with the dollar in 2009--they can quickly flip the other way.
The year 2010 provides a vivid case in point. Amid troubles in the eurozone, primarily in Greece but with rumblings in Spain, Portugal, and Ireland, many investors have concluded that the US might not be in such bad shape after all. The dollar has appreciated sharply versus the euro during the past few months. CurrencyShares Euro Trust, an ETF that's set up to capture the euro's movements versus the dollar, has declined nearly 11% during the past three months; a similar ETF tracking the British pound has also posted a loss, albeit a smaller one. (Performance of the Japanese yen versus the dollar has been more mixed.)
All of this is yet another in a long line of examples illustrating the danger--and some might say the futility--of currency speculation. Notwithstanding a few notable winning currency bets, such as George Soros' wager against the pound in 1992, even many professional investors have been unable to successfully predict the direction of currencies. Franklin Templeton Hard Currency, the oldest currency-specific fund in existence, invests in money market securities denominated in international currencies deemed undervalued by its managers. Its 10-year return has been underwhelming, though, at just 5.5%--about the same as a short-term bond index fund's return but with 3 times the volatility. Investors in the currency fund haven't timed their purchases of it particularly well, either, with 10-year annualised investor returns that fall 2 percentage points shy of the fund's published total return.
So does this mean it's best not to monkey with individual currency bets? My vote would be yes, unless you're using money you can afford to lose and thinking of your bet as an alternative to playing craps in Vegas. Some of the currency-specific ETFs could also have utility for individuals in very specific circumstances--such as people who are planning to relocate abroad.
Yet, even though I'm against foreign-currency speculation, that's not to say investors shouldn't have foreign-currency exposure in their portfolios. If the dollar is in a state of long-term decline versus other currencies--and recent events don't rule out that possibility--non-dollar exposure will allow portfolios to benefit from that trend. And in any case, maintaining some long-term exposure to international currencies is another way to diversify your portfolio, which could, in turn, improve its risk/reward profile. Most international-stock funds do not hedge their foreign-currency exposure and unhedged foreign-bond funds provide another, even more direct source of foreign-currency exposure.
Christine Benz is Morningstar's director of personal finance.
