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.