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."