Which way the U.S. dollar will go is a question.

Longer term, money managers expect the dollar to decline due to the U.S. government deficit and slow economic growth. Money, at this writing, already was flowing into higher-yielding currencies. Only when the Fed starts tightening by raising short-term interest rates, which some expect to happen in 2012, is the dollar apt to strengthen.

"As soon as the Fed starts to position itself for eventual monetary tightening-long before it eventually hikes interest rates, which we do not expect until the second quarter of 2012-[will] the dollar ... rally," says Katherine Klingensmith, strategist at UBS Financial Services in New York.

However, the World Bank paints a gloomy long-term picture for the U.S. dollar. Its dollar report last June predicted the decline of the U.S. dollar as the world's major reserve currency by 2025. It cites emerging economies, which are expected to grow at 4.7% annually-more than twice the 2.3% annual rate of advanced economies.

The greenback, the report says, will be replaced by a multi-currency system.

Not everyone is bearish on the U.S. dollar, which last May hit its lowest point since 1971, when the 1944 international Bretton Woods (New Hampshire) system of money management agreement ended. The termination of that agreement, signed by 44 nations, ended the convertibility of the U.S. dollar to gold, leaving it backed by nothing more than a U.S. government promise. A Reuters poll of 61 analysts last June indicated that the dollar could strengthen if the global economy weakens.

Nevertheless, concerns about the demise of the U.S. dollar have prompted some financial advisors to tactically integrate currencies into client portfolios. Foreign currencies typically are more liquid than other types of assets and have no correlation to U.S. stocks and bonds.

George Feiger, Ph.D., the CEO of the money management firm Contango Capital Advisors in San Francisco, is one example. Shorter-term strengthening of the U.S. dollar is not due to stronger economic fundamentals, but to problems in the rest of the world, Feiger says. Over the short term, he was keeping money in U.S. investment-grade bonds with a duration of four years or less.

"The Fed is keeping rates low at the short end to stimulate the economy and to keep the government deficit from ballooning if they raised interest rates," Feiger says.

Low interest rates at home and higher rates abroad spell dollar weakness, he believes. He invests in U.S. dollars due to global economic concerns. But longer term, he expects market conditions will change, and he will move into foreign currencies.

"I think it's important to diversify with foreign currencies," says Feiger, who manages more than $1 billion in assets. "But there is the issue of timing."

Concerned about Uncle Sam's debt and the falling dollar, Greg Womack, an Edmond, Okla.-based financial advisor, says he has been successful in improving client risk-return portfolio profiles by holding some foreign currency mutual funds. Among those: Franklin Templeton's Global Bond Fund and its Hard Currency Fund. Both mutual funds have registered positive returns over the last three-year and five-year periods.

If advisors take currency positions, Feiger recommends using a number of technical and momentum indicators to invest in foreign currency exchange-traded funds, CDs or high-quality bonds. Those indicators identify rates of change in such factors as foreign exchange values, economic variables, commodity prices, interest rates and inflation. Political and economic policy changes also are important factors to consider.

Evaluating purchasing power parity is an important decision-making tool, he says. The buying power of different currencies is equalized based on goods bought and sold in the marketplace. The difference in the rate of change in currency prices in the United States and overseas is essentially due to inflation rates. So the difference in inflation rates between countries is equal to the percentage rise or fall in the exchange rate, he says. As a result, if one currency can buy more goods and services than another currency, it is more valuable, demand for the currency increases and that currency appreciates in value in relation to another currency.

"It [purchasing power parity] works quite well over the long term along with [currency] momentum," he says. "But not for day trading."

The notion that currency should be an important component in a diversified portfolio is supported by research, published by Mitchell Ratner, associate professor of finance at Rider University in Lawrenceville, N.J.

His study, published in the July 2007 issue of the Journal of Financial Planning, found that from 1975 through 2006, adding a basket of six foreign currencies to a portfolio of U.S. and foreign stocks improved the portfolio's Sharpe ratio compared with an all-stock portfolio. The Sharpe ratio measures the return per unit of risk. The higher the Sharpe ratio, the better.

Ratner suggests that financial advisors keep 5% of a client's portfolio in currencies and 20% to 30% in foreign stock and bond funds. For risk-averse clients, he suggests investing in foreign currency CDs or a basket of foreign currencies.

But buying and holding foreign currencies can be risky and volatile, according to a 2011 study published in the Journal of Portfolio Management by Michael Melvin, finance professor at Arizona State University. His research shows there are no benchmarks for evaluating a currency manager's performance. So how will a financial advisor who doesn't specialize in currency investing perform?
Few money managers have enough skill to time the foreign exchange markets. Those who are successful are the ones that minimize losses, he adds.

A less risky and popular alternative is investing in foreign corporate bonds. Diversification among foreign government bonds does not significantly affect the risk-adjusted rate of return on a diversified bond portfolio, according to a 2008 working paper by Mats Hansson, finance professor at the Swedish School of Economics in Helsinki, Finland. However, currency-hedged corporate bonds offer diversification benefits. Adding emerging market debt significantly improves the return per unit of risk.    

But there is no free lunch. The short-term volatility of directly investing in foreign currencies via bonds can be dangerous. Historically, changes in foreign currency values have played a larger role than interest rates on the total return of overseas bonds. For example, in 2004 nearly half of international bond fund returns were due to the decline in the U.S. dollar, according to Morningstar Inc. in Chicago.

On the stock side, a study by Dirk Hofschire, vice president of Fidelity Investments in Boston, found that over the 25 years ended in 2010, changes in currency values had a slightly negative correlation with local currency-denominated stock prices. This suggests that changes in the prices of foreign stocks have little relationship with the exchange-rate value of the U.S. dollar.

Currency diversification may play an important role in financial planning. Published reports indicate that private bankers at Citigroup, JPMorgan Chase, UBS, Credit Suisse, HSBC and Standard Chartered are diversifying wealthy clients into currency products, particularly the Chinese yuan or a proxy. Reason: The yuan is expected to appreciate in value as China makes its currency available on the foreign-exchange market rather than relying on government control. HSBC Holdings offers clients forward currency products, options and bonds in the yuan.

And a survey of 1,100 members released last May by the Institute for Private Investors, a New York-based organization that represents family offices, found that one in four members is concerned about inflation and dollar devaluations and is thus managing currencies or hedging currency risk. The survey respondents have an average net worth of $30 million.

International long equity investments make up about 14% of the institute's member portfolios. Of those that are managing currency risk, 53% are using a currency overlay strategy or manager, 24% are using derivatives and 18% are using exchange-traded funds. Alternative investments make up 42% of those investor portfolios, hedge funds 19% and fixed income 25%.

Affluent Americans living abroad also need to make financial planning decisions based on currency values, says David Kuenzi, a financial planner with Thun Financial Advisors LLC in Madison, Wis. His company specializes in U.S. investors that live abroad.
He recommends that some who intend to live overseas for a lifetime have as much as 60% of their portfolios in foreign currency assets. On the cash side, money is kept in foreign currency CDs or exchange-traded currency funds to meet shorter-term financial planning needs.

Kuenzi typically invests in U.S. dollar-denominated exchange-traded funds and mutual funds converted to foreign currency to invest in overseas assets. Assuming the dollar goes into a prolonged decline, clients living in Europe would have a euro-centered portfolio. But clients who return to the United States will find they are insulated from the decline in the dollar, he adds. Clients who remain in Europe for the long term and use euro investments to meet their financial needs will not be affected by the strengthening of the dollar.

"Americans abroad are most likely to find themselves suffering under the negative impact of currency risk when 'life assets' accumulated to fund 'life liabilities' are denominated in different currencies," he says. "If the dollar does go into a period of decline and you are planning on living in Europe, a proper euro-centered portfolio of investments will protect you. On the other hand, if you are returning to the United States, then you will find you are relatively insulated from the decline in the dollar."