Dollar’s rally may spell trouble for foreign funds

With the U.S. dollar staging a surprising rally, investors who have piled into foreign stock and bond funds may get burned, some market watchers say.

After all, if the dollar continues to move up against other currencies, returns on foreign investments will suffer.

Unlike European investments, “the vast majority of international stock and bond holdings in the U.S. are not currency-hedged,” said Bradley Kay, an exchange-traded-fund analyst at Morningstar Inc.

Those who took on currency risk last year were rewarded: Foreign currencies rallied right along with their underlying equity markets.

As U.S. investors fled domestic stock funds and put some of their money into foreign funds, the MSCI EAFE Index gained 27.75% in dollar terms in 2009, and the MSCI Emerging Markets Index ran up 74.5%. On a similar price basis, the S&P 500 gained 23.45%.

But the profitable combination of strong foreign markets and a falling dollar is unlikely to be repeated this year, said Anthony Welch, a partner at Sarasota Capital Strategies Inc., which has $70 million in client assets.

The 5% surge in the dollar last month versus other major currencies occurred as fiscal crises in Dubai and Greece revealed underlying problems outside the United States. Those concerns caused dollar bears to pull back on short bets.

For market technicians, the move up in the dollar was significant because it broke a down trend going back to May.

Historically, “the dollar tends to pick a trajectory and stick with it. If there is a change [in trend] it can continue for a while,” said David Waddell, chief executive of Waddell & Associates Inc., which has $525 million under management.

The dollar rally looks different from the last run-up, which began in the summer of 2008 when investors rushed into U.S. dollars in a panic, analysts said.

Now, with the U.S. economic picture looking somewhat better than that of other developed nations, investors have driven up the dollar on fundamentals.

Analysts expect some modest dollar appreciation this year, up to 10% against the euro and yen, with the euro holding up a bit better.

Currencies of emerging markets are expected to hold their own or even appreciate against the U.S. -dollar.

Nevertheless, emerging-markets holdings could be especially vulnerable to a decline, after having surged last year, some observers said.

“If emerging-markets currencies start falling against the dollar [and] emerging-markets holdings fall [in price] too, we’ll have the opposite of what happened last year,” said Mr. Welch, who co-manages the Currency Strategies Fund (FOREX).

NO FOOLISH BETS

What’s more, a strong dollar and higher short-term rates in the United States, the latter of which helped spark the dollar’s rally last month, could force the unwinding of dollar carry trades, which in turn could create selling pressure on emerging-markets assets. Carry traders may pay off their dollar-denominated short-term financing as rates rise and the dollar appreciates, and then sell the assets they hold, which are believed to include sizable holdings in emerging-markets debt and equity.

Despite the risks of a stronger dollar for international holdings, analysts and financial advisers said that it is foolish to make bets on currency movements.

Most investors should have significant allocations to foreign stocks because of the favorable growth trends overseas and should maintain broad currency exposure as well, they said.

“People in the U.S. generally are vastly invested in U.S. equities, which doesn’t provide good diversification,” Mr. Kay said.

“You’re better off owning a basket of currencies, rather than trying to predict” which will do best, Mr. Waddell said. “You should have as much geographic and currency diversification as possible.”

Thomas McGuirk, a principal at Martin Thomas Wealth Management LLC, which manages $110 million for clients, makes a small allocation to a currency fund, the Merk Hard Currency Fund (MERKX).

“We just think currencies are an asset class we need exposure to,” he said.

Currencies are unique assets because some will appreciate versus others regardless of what global economies are doing, Mr. Welch said.

In terms of markets, most observers still like the emerging nations, despite their risks.

“They have higher growth [and their] fiscal deficits are more sound,” said Aldo Roldan, managing director and associate portfolio manager at BlackRock Inc. and a member of the firm’s global allocation team.

Commodity markets continue to look strong, which helps the emerging nations overall.

“Europe, and especially Japan, look [about 10% to 20%] cheaper than the U.S.” on a price-cash flow and price-earnings basis, which could make them attractive longer term, Mr. Kay said.

That discount could be due to the fact that most observers think that the U.S. markets offer better growth potential than other developed nations in the near term. And if the dollar firms, domestic returns should be better this year.

E-mail Dan Jamieson at [email protected].