Examining ways to profit from changes in foreign currency values.
After a brief rally early this year, the U.S. dollar
had resumed its decline in late February. To many observers, the huge
U.S. budget and current account deficits are a harbinger of further
declines, as was the statement by the Bank of Korea that it would
curtail purchases of dollar-denominated assets. So if your clients are
invested overseas, here are several ways to play the change in currency
values.
International bonds may be one of the easiest ways
to benefit from the falling dollar. Nasri Toutongi, manager of the
Hartford Total Return Bond Fund, expects overseas bonds to register
total returns of at least 12% this year.
Historically, changes in foreign currency values
have played a larger role than interest rates on the total return of
overseas bonds. And nearly half of last year's foreign bond fund total
returns were due to the decline in the dollar.
"We expect the dollar to decline by another 10%
against the euro due to the current account and budget deficits,"
Toutongi says. "We see opportunities in foreign government bonds,
particularly Western European bonds. They offer safety and can benefit
from currency appreciation.
"While we expect yields on U.S. bonds to rise due to
the strong economy and an increase in the Federal Reserve rate, we
expect western European government bonds will decline in yield due to
the weak economy and stimulative monetary policy."
Toutongi believes that it's better to benefit from
the drop in the dollar via bonds rather than stocks. "There are a lot
more variables that affect the price of foreign stocks," he explains.
"Foreign stocks are thinly traded. But foreign government bonds are
highly liquid."
Foreign government bond price movements are tied to
macroeconomic factors. By contrast, foreign stock prices are driven by
microeconomics, fundamentals and earnings expectations.
Toutongi recommends that financial advisors stick
with foreign bond funds for their clients rather than individual bonds.
Reasons: Investors pay a big mark-up when the buy individual foreign
government bonds. Bond funds get better prices due to large block
purchases. In addition, bond fund managers can hedge against currency
losses when the dollar begins to gain strength.
Toutongi favors German, French and Italian
government bonds that mature in two years. The bonds yield 2.5%. He
also likes Australian bonds, which yield more than 5%. Although
Japanese bonds sport low yields of up to 1%, the yen should also
strengthen against the dollar.
Foreign currency CDs are another option. EverBank,
www.everbank.com, offers FDIC foreign currency CDs denominated in 20
currencies-including the euro, yen and currencies in smaller countries.
The CDs mature in three months to 12 years, and interest is paid in
foreign currencies. The bank also offers CDs that invest in an index of
currencies. A "commodity CD" invests in the currencies of countries
that produce commodities, such as South Africa and Canada. "Petro CDs"
are denominated in currencies of countries that produce oil. There also
is a foreign currency money market mutual fund.
Recently, for example, the CDs range in yields from
0.5% for a one-year Norwegian krone CD to 4.8% for a New Zealand dollar
CD. Minimum initial investments range from $10,000 to $20,000.
Investors who cash out CDs early pay an early
withdrawal penalty. But those who invest in noninterest bearing CDs as
a currency play can withdraw cash penalty free.
The CDs are insured for the market value of their
accounts by the FDIC if the bank defaults. But investors still face
foreign currency risk. If the U.S. dollar appreciates relative to other
currencies, the investor could suffer losses when the CD matures or is
cashed out early.
Major banks, like Credit Suisse, Citibank, HSBC,
Washington Mutual, Bank of America and J.P. Morgan, also have foreign
currency CDs.
Foreign currency futures are another option. Futures
are contractual agreements made between two parties through a regulated
futures exchange. The parties agree to buy or sell an asset, such as a
foreign currency, at a certain time in the future and at a mutually
agreed upon price. Each futures contract specifies the quantity and
quality of the item, expiration month and the time of delivery of the
asset in the cash or commodities, such as potatoes.
The foreign currency market, however, is a cash
market. There is a cash settlement at contract termination. Typically,
investors do not hold their futures contracts for the full term. They
sell early.
There are several ways to invest in foreign currency
futures. You can trade 36 different foreign currency futures on the
Chicago Mercantile Exchange (CME).
It works this way: Say you buy one euro currency
contract based on the euro trading at $1.3050. The investor would have
to place $3,000 in his clearing account to trade one lot of 100,000
euros worth $130,500. If the euro appreciated 5% against the dollar to
$1.3703, the contract would be worth $137,030. The investor would make
a profit of $6,530 on the sale of the contract. But if the euro
declined 5% against the dollar, the investor would lose the same amount.
Investors use foreign currency futures to speculate
or hedge existing overseas investments. By speculating, investors can
go long or short on a foreign currency future.
Hedgers take a different stance. To protect profits
in stocks or bonds, they can own asset-denominated foreign currencies.
They also may short foreign currency futures. The futures should
increase in value if the foreign currency weakens against the dollar.
The gain in the futures contract offsets losses in stocks and bonds
purchased in foreign currencies.
Hedging currencies of overseas stock holdings can
boost risk-adjusted rates of return over the long term, according to
a study by Robert Doyen, a CME analyst.
His study, from January 1980 through June 1999,
showed that the hedged Morgan Stanley Capital International Europe,
Australasia, Far East (MSCI EAFE) index in U.S. dollars delivered a
1.69 return per unit of risk compared with 0.77 return per unit of risk
for the unhedged MSCI EAFE.
Although trading or hedging currencies looks
appealing in this day and age of the falling dollar, there are risks.
Currency trading involves market-timing decisions, which often can be
wrong. A financial advisor must have a sophisticated technical trading
system to be effective. But those systems are not foolproof. Dramatic
changes in currencies may occur over brief periods. As a result, it is
easy to make mistakes.
"It can be a full-time job managing currencies,"
Toutongi said. "You can get whipsawed using simple trend models."
Toutongi says foreign currency arbitrage tactics may be a less risky
alternative. For example, a currency swap lets an investor profit from
the difference in interest rates between two countries. The investor
would borrow funds in low-yield currencies and invest in
higher-yielding currencies. For example, the investor could borrow
Swiss francs at low rates of 2.5%, and invest in the Australian dollar
in bonds that yield 5.5%. The investor, as a result, pockets the
interest rate difference of 3%.
Covered interest arbitrage is another tactic for
investors purchasing assets in a foreign country. In a nutshell,
covered interest arbitrage is the process of capitalizing on the
interest-rate differential between two countries, while covering the
exchange-rate risk. It works this way: Say you purchased stocks, bonds
or other assets in a foreign currency. You would hedge the foreign
exchange risk by selling the proceeds of the investment forward for
dollars. Businesses often use covered interest arbitrage to cover the
cost of goods imported in the event of changes in currency values.
Foreign currency commodities funds and hedge funds
are another way to invest. If you are looking to diversify a portfolio,
Sol Waksman, president of the Barclay Trading Group in Fairfield, Iowa,
recommends a foreign-currency managed futures account. These are
professionally managed pools that invest in foreign currencies. Annual
fees run about 2%, and most funds take 20% of the profits.
Waksman says combining a currency fund with stocks
and bonds can improve risk-adjusted returns over the long term. The
Barclay Currency Traders Index, an equally weighted composite of
managed programs that trade currency futures representing 72 funds, has
a -.04% correlation with the S&P 500 and.08% and.13% correlation
respectively to U.S. bonds and world bonds.
"I would invest 3% to 5% of assets in foreign
currencies for diversification," he said. "The currency trading funds
have a low correlation to stocks and bonds."
But Waksman warns that currency funds can be risky.
His research over the past couple of years shows that making room for
managed futures accounts in a 60%-40% split stock-bond portfolio did
not help the portfolio's risk-return relationship. One major reason was
the bull market in bonds and stocks over the past two years.
Another problem over the short haul: There can be
wide performance swings because currency funds can change their
investment strategies dramatically. "You can't look at returns when
selecting currency managed programs," Waksman says. "You need to look
at the volatility-the worst period of performance. Invest assuming that
you could lose as much."
The top three currency traders over the past five
years ending in 2004, according to Barclay's include FX Concepts,
which grew at a 8.14% annual rate; Grossman Asset Management, which
grew at a 9.73% annual rate; and Analytic Investment Management, which
grew at a 10.35% annual rate.
Swiss franc annuities are a more conservative way to
take advantage of the declining dollar. Many investors also consider
Swiss annuities to be a safe haven during tumultuous times.
Darrell Aviss, managing director of SwissGuard
International, a Zurich-based brokerage firm, says that Americans put
$2 billion in Swiss franc annuities in 2004.
The reasons: Swiss francs are considered one of the
world's steadiest currencies. Switzerland avoids government deficits.
By choice, the Swiss government backs its currency with gold bullion.
In addition, Swiss insurance companies are required to set up separate
reserves to back 100% of their annuity obligations.
The Swiss also have a tradition of secrecy when it
comes to dealing with investors' money. In Switzerland, there are no
foreign reporting requirements or forced repatriation of funds. Under
Swiss law, an annuity cannot be seized by any court-ordered collection
procedures instigated by creditors.
The Swiss government does not tax annuity income.
And the insurance companies do not send 1099 interest and dividend
forms to the IRS. But investors are required to report the fixed
annuity interest income on their U.S. tax return, based on IRS rule
1.1275-1.
Aviss says a five-year fixed rate annuity pays a
guaranteed rate of 2.5% annually, plus a 1.5% dividend for a total
annual rate of 4%. Dividends are insurance company profits that are
passed on to policyholders. Over the past five years, the annual total
compounded rate of return on Swiss fixed-rate annuities is more than
8.18%, due to the decline in the value of the dollar.
Investors can purchase annuities from the follow
Swiss brokerage firms: SwissGuard, JML and BFI Consultant, all in
Zurich, and Volcon in Basel. The brokers deal with the major annuity
issuers such as: Pax Life Insurance and Helvetia Patria Insurance, both
in Basel, and Generali Group in Adliswil.
The drawback: Your clients won't do that well if the dollar weakens.
Alan Lavine is author of numerous books and a contributing editor to Financial Advisor.