U.S. Investors Not as Dollar Diversified as They Think
There is a broad consensus among economists and analysts that the U.S. dollar is headed lower against other major currencies over the long term -- perhaps even sooner -- and many investors have tried to anticipate this decline in their portfolios by diversifying into foreign currency holdings.
However, a new research report suggests that they may not be nearly as diversified as they think they are.
For most American investors, the easiest and most popular method to diversify out of the dollar has been to buy shares of large U.S. global firms like Exxon or General Electric which derive a substantial portion of the revenue and profits overseas, either through export sales or from foreign-based operations.
Merk Investments, however, in white paper titled U.S. Investors Overexposed to U.S. Dollar Risk?, warns that buying these companies' shares offers little in the way of genuine foreign currency exposure.
The underlying theory is that by investing in a U.S. corporation that has significant international operating earnings, an investor is essentially creating de-facto exposure to the currencies where those international operations are located,” write the paper’s authors, Axel Merk, president and CIO, and Kieran Osborne, director of research.
"However, this de-facto currency exposure may be limited, depending upon the extent to which the business employs economic hedging to its foreign currency exposures."
The authors go on to say that surveys of the foreign exchange departments of various large multi-national banks suggest that roughly 80% of the international income of U.S. multinational corporations is hedged back to U.S. dollars.
Furthermore, the larger the company, the more completely hedged those earnings tend to be. At best then, an investor who buys a globalized U.S. company to diversify beyond a portfolio’s dollar-denominated holdings is only getting a one-fifth of the diversification he or she imagines -- and perhaps considerably less than that.
The study’s conclusion: "While approximately 46% of U.S. corporate earnings may be derived from abroad, the un-hedged portion that provides investors with international currency exposure actually only amounts to approximately 8.9% of total U.S. equity exposure. This equates to approximately 2.1% of the U.S. personal sector’s aggregated asset allocation.”
Adding in the international equities and foreign currency bonds that are held in U.S. investors’ portfolios, they estimate that U.S. investors on average are approximately 10.7% exposed to foreign currencies -- a degree of diversification that they say is probably too low and that is certainly lower than many investors may think.
Merk and Osborne note that the U.S. dollar declined 10.91% in the one-year period ended April 2011, fell 13.81% over the past two years, and that it has declined 7.71% year to date.
They argue that in the current environment, protecting portfolios against a decline in the U.S. dollar “may be of the utmost importance” because of the number of goods and services that end up rising in price in the U.S. as the dollar loses value.
They also warn that there is a “significant risk” of continuing weakening of the dollar going forward.