Secret to diversifying: Do it in yen

By Roger Ibbotson

When most investors think about diversification, they tend to think about dividing their money among asset classes -- large- and small-cap domestic stocks, international stocks, bonds and cash -- and then selecting a variety of investments to fill the asset allocation.

Investors may even consider more alternative asset classes like real estate, commodities or even timber. But diversification doesn't just come from adding new asset classes to a portfolio. Investors can also gain diversification through changes in currency exchange rates.

Simply put, if the dollar loses value vs. the yen, it's better to own yen or stocks or bonds that are denominated in yen.

Low correlation

Of course, it's a bit more complicated than that, and there are other factors at work. Typically, the return or loss on an investment is composed of two factors -- for stocks, it's price appreciation or depreciation and dividend return; for bonds, it's price appreciation or depreciation and interest payments. But some investments also have a currency factor that can dramatically affect the total return, adding an additional layer of diversification. For example, if a U.S. investor purchased a 1 million yen, five-year bond at an exchange rate of 115 yen to the dollar, the cost would be approximately $8,696. If the yen gained against the dollar over the next five years so that the exchange rate dropped to 100 yen to the dollar, the investor would get a principal payment back of approximately $10,000 when the bond matured -- a significantly higher profit than the investor would have made on the interest payments alone.

The exchange rate between the U.S. dollar and the other major currencies can fluctuate dramatically and is particularly difficult to predict. Foreign currency rates tend to be roughly as volatile as domestic long-term government bonds -- not like investing in small-cap stocks, but substantial nonetheless. This high variability also makes exposure to foreign currencies a particularly good portfolio diversifier, since the relative strength of the dollar rarely moves in tandem with either the U.S. stock or bond markets.

Here's a look at the main options for gaining currency exposure for your portfolio:

Foreign equity

Investors interested in gaining currency exposure are most often steered toward foreign equity funds. The conventional wisdom is that an investor's dollars are converted into yen or euros or rupees and used to purchase stock. When the investor sells, his or her profits or losses are converted back into dollars and the change in purchasing power results in additional profit or loss. How much currency exposure these funds actually provide, however, depends on how much the international companies in the fund rely on global exports as their source of revenue.

When a foreign company that sells its goods and services domestically experiences currency appreciation, its costs, prices, profits and stock price rise commensurately. While it's a wash for the company and its domestic investors, foreign investors stand to profit from both the stock price and the currency appreciation.

Foreign companies that are global exporters, however, are another story. When a foreign country's currency rises, costs also rise. But the increase in costs can't often be passed along to foreign importers, so the company takes a financial hit, which is usually reflected in the stock price. The U.S. investor holding stock in this international company benefits from the foreign currency appreciation, but the falling stock price wipes out those gains. The majority of commercially available international mutual funds invest in large, well-established foreign companies, which are predominantly net exporters.

International bonds

Investing in foreign currency directly is a possibility, but you can get the same currency exposure and an interest payment by investing in foreign bonds. International bond investing is essentially a commitment to be paid in the bond's currency at some future date with regular interest payments in the interim. But international-bond-fund investing does have a drawback: taxes. Bonds pay significant interest payments, which are taxed at the regular income rate of 35%, as opposed to capital gains that are taxed at just 15%.

There are some currency-specific mutual funds that invest in foreign short-duration bonds or money market funds where interest payments aren't an issue. But there are relatively few of them, most have a short performance history and may have high expenses.

Gold, the original currency

Another alternative is gold. Gold can act as a proxy for direct currency exposure, because like foreign currency, it tends to move in the opposite direction from the dollar. If the Japanese yen rises relative to the U.S. dollar, for example, that means that the U.S. dollar falls relative to the yen -- they must move in opposite directions. Gold performs in a similar fashion -- when the dollar declines, gold prices usually rise. And since gold doesn't pay interest, it's taxed at the lower capital gains rate. Gold also tends to be stable in real terms. Over time, it generally grows at the rate of inflation, making it an excellent hedge during high inflationary periods.

Investing in gold is not for the short-term investor. Gold prices have approximately doubled over the last four years, making them particularly risky in the near term. But its fundamental characteristics as well as some longer-term economic factors suggest that gold should be a good strategic long-term investment. Until the U.S. reins in its trade and budget deficits, there's no reason to believe that the dollar will strengthen significantly. Gold also has a negative correlation with the broad U.S. stock and bond markets, making it an excellent diversifier. If you can stand the volatility -- which is even higher than that for stocks -- gold can provide the diversification benefits of currency exposure without giving up a big chunk of return to taxes.

Roger Ibbotson, Ph.D., is founder of Ibbotson Associates, a Morningstar company, and a professor of finance at the Yale School of Management.