Investment trends can take a long time to play out but most all trends will reverse course eventually. Even foreign exchange markets, which can set decade long trends, reverse course. Why is this important to you? There are a number of reasons.

If you own a foreign stock or bond fund you are taking foreign currency risk*. How? Well, when your fund decides to invest in a company like Mercedes Benz they have to pay for the stock in the local currency, in this case in euros. To do that the fund converts the dollars you’ve invested in the fund into euros. If at time they made that conversion the dollar to Euro exchange rate was 1 to 1, then your $10,000 bought 10,000 euros worth of Mercedes stock. Now let’s say a year later you want to redeem your investment in the fund so the fund company sells the Mercedes stock. Let’s further assume that the stock price at that point is unchanged but the dollar has gotten stronger so the exchange rate is now 0.8 dollars to 1 euro. Since you’ll want your money back in dollars the fund has to exchange the 10,000 euro position back into dollars but now due to the stronger dollar it’s only worth $8,000, a 20% one year loss. The stock investment is unchanged but you still lost money because of the change in the currencies. This principle also works the other way; if the dollar was weaker then you’d have made money even though the underlying stock was the same. The fact is the dollar has gotten weaker over the last ten years or so, a lot weaker, and this has added tremendously to the investment returns in most foreign funds. The problem is when this trend reverses, and the dollar strengthens, that currency return will work against you just as dramatically has it has worked for you these past years.

That trend reversal is coming. At the dollars strongest point it took only $.80 to buy one euro but today that same euro will cost close to $1.70, more than double what it cost about ten years ago. The dollar, to put it bluntly, has gotten killed. In fact the dollar has gotten so cheap that now foreigners are finding US investments very attractive (not to mention US vacations and real estate) so more and more foreigners are converting their currencies into dollars which, of course means the dollars slide may soon be ending. When that happens the returns on your international investments are likely going to suffer.

What should you do? For starters rebalance. Chances are your foreign funds have done very well these past few years and it’s time to take some money out of that category. Also, think twice about adding additional assets to investments that will be hurt by a strengthening dollar. Finally, shift at least some of your international investments into funds that will hedge (offset) the currency risk and protect you from a strengthening dollar.

It may take a while for the trend toward a weaker dollar to reverse itself but if history is any guide that day is rapidly approaching and soon the dollar may be on a long term upward trend. The downward trend of the dollar has been in place for almost ten years and sooner or later will come to and end so think about addressing the currency risks in your portfolio before it’s too late.

Randy Gridley

May, 2008

* Some foreign investment fund hedge out the currency risk but the majority of them do not.