As if investors don't have enough to worry about as they wrestle with the proper allocation of stocks, bonds, commodities, and hedge funds, and philosophical questions regarding passive versus active management, here comes another beast to tackle–currency exposure.
We should blame this problem on the stellar returns of global equities. Quick to ride the gravy train, many U.S. investors have committed significant capital to both emerging and international mutual funds. The result has been increased interest on the direction of the U.S. dollar, which can significantly affect the value of such investments depending on whether currencies rise or fall in value.
Central to the currency conundrum is the fact that if one buys foreign securities, they must do so with the currency in which that asset is denominated (i.e., British stocks are purchased with British pounds, etc.). As a result, a domestic investor with a foreign portfolio is making an implicit bet that the dollar will lose value relative to the currency of the host country in which he is investing.
That's been a pretty good bet to make, as the greenback has lost ground to most major currencies over the last few years. But the recent surge in the dollar's value has surprised a plethora of market experts, who expected further declines as the nation's twin deficits increase. If the U.S. economy continues experiencing strong growth, the Federal Reserve might be forced to raise short-term rates even higher, which could create a sustained dollar rally.
Investors facing such a dilemma have several choices. One solution is to utilize a fund that hedges away its currency risk. There is a plethora of global bond funds that hedge away such exposure, and their returns are much less volatile than those for unhedged bond funds. However, unhedged funds can be a real return driver when the dollar falls. In the end, it all comes down to the investor's objectives and their expectations for the dollar.
