AskDong

I’m generally pretty happy with my investment allocation. My investments don’t leave me awake at night. My performance is steady if not spectacular. I do a good job of re-balancing at least once a year. However my re-balancing has caused me some concern as of late. I’ve been consistently re balancing away from foreign holding (international and emerging market funds) into U.S. funds (mostly midcap and largcap). Much of this has been fueled by the very strong performance of emerging market funds, China and Brazil funds certainly come to mind, and some by the eroding dollar. As the dollar erodes against other currencies, everything else the same, foreign stocks rise in dollar terms just because the dollar is able to buy fewer shares of company that are denominated in the foreign currency. Given that I’ve re-balancing away from foreign funds, I’m worried that I may not be properly hedged against a continued fall in the dollar.

Apparently like Warren Buffet and Gisele Bunchuden, I believe the dollar has more to depreciate. Though, Gisele has now denied that that she wants to be paid in Euros. Why should we care that the dollar is falling? Before I get into that, we need to look quickly to why the dollar is falling. Americans imported nearly 2.2 trillion worth of goods in 2006 which was equivalent to nearly 20% of the GDP (Gross Domestic Product). Imports constitute a significant portion of our spending. Part of the reason for the declining dollar is the fact we import so much more than we export. Since we pay in American dollars we flood foreign countries with excess dollars. The other factor fueling the decline of the dollar besides the balance of trade is monetary policy. The Federal Reserve which controls the money supply (basically how much money is in circulation) is believed by many to have been liberal with the money “printing press”, i.e. creating too much money in times of need like this past summer. The net result of our trade deficit and Fed policy is that we basically have too many dollars in circulation. Whenever you have too much of something, in this case dollars, the value of that something becomes diminished.

In itself a weak dollar is not a bad or good thing, however the weak dollar is both symptom a cause of something we do need to concern ourselves with, inflation. Even if an individual does not directly buy many imported goods, that individual is still affected. Imported goods for example, oil, serve as the raw material of many domestically produced goods. Given so much of American consumption and production is made up of imports, a weak dollar will lead to higher prices in most goods. In addition the Fed’s loose monetary policy contributes directly to higher inflation. Monetary policy is considered loose when the central bank freely “prints” more money. The bank doesn’t literally print money, but its policies on interest rates, and reserve rates (the required percent of deposits that banks actually need to hold instead of lending out) changes the money supply even more quickly.

So what are some thing we can do to protect ourselves from the declining dollar?

1. Increase allocation to foreign funds
2. Commodity Funds
3. Inflation Protected Securities
4. Selling Dollar Futures/Buying Foreign Currency Futures
5. Buying real estate outside the U.S.

I’ve ordered them by degree of difficulty. Buying foreign mutual funds is the easiest thing to do. I’m splitting my monthly ongoing Vanguard purchases between VTSMX (Vanguard Total U.S. Market) and VFWIX (World Market ex-US). While I haven’t done any futures trades, I have the option in my account at OptionsXpress. A Future Contract for who don’t know is a contract that entitles you to buy or sell at some price in the future. Buying real estate is hard enough in itself, buying real estate in foreign country doubly or triply hard. I imagine there are some REITs (Real Estate Investment Trusts - Real Estate Mutual Funds basically) that specialize in foreign holdings, but I haven’t done enough research to know any specific ones. Buying commodity funds and inflation protected securities don’t directly protect against the decline in the foreign exchange, but does offer some shelter from the overall inflation risk.

Right now might be a great time to buy TIPS, especially in a tax advantaged accounts such as Roth IRA or 401k.   For those who aren’t familiar with TIPS.  TIPS are Treasury Inflation Protected Securities.  So what are they?  They are U.S. government bonds similar to the 2 Year Note or 10 Year Bond offered in 5,10, and 20 year maturities.  The difference is unlike regular government bonds which have a fixed interest payment, the “interest” payment on TIPS has two parts, the “regular” interest and an inflation portion.

The regular interest portion behaves mostly like interest on any other U.S. Bond.  The payments are made semi-annually.  The tricky part is that the underlying “face” value of the bond varies.  Typically a bond with a face value of 1000 will have it’s interest payments, say 5%, based on that face value.  Hence annually the interest payment would be $50 on a $1000 bond.  With TIPS that face value is adjusted for inflation.  So if inflation rate 5% in one year, the interest payment instead of being 5% of 1000, would be 5% of $1050 or $52.50. $1050 is the principal amount adjusted up to reflect the 5% inflation that has occurred.

The problem with bonds, and especially TIPS is a problem of taxes.  Even though U.S. Government issued securities are exempt from state and local taxes, you still have to pay federal taxes on them.  This is a problem with all bonds, but especially a problem with both TIPS and Zero Coupon Bonds, bonds that do no make annual (semi-annual) interest payments.  In the case of the Zero Coupon Bond, all implied annual interest is effectively paid out when the entire bond matures.  However taxes on that implied interest must still be paid even though the Bond itself makes no annual interest payments.  In the case of TIPS, taxes need to be paid on both the interest payment, and the principal adjustment.  Like the interest on the zero coupon bond the principal adjustment does not actually become realized until the bond matures.  As a result, taxes need to be paid on income that never actually gets distributed in that year.

So why am tipping towards TIPS?  As I’ve indicated before I’m concerned with the health of the U.S. Economy even with the half point cut the Fed made earlier this September. I’m about as invested (in the stock market) as I want to be given the prevailing economic conditions.  I even took some steps to hedge my exposure to the stock market in August.  Those hedges haven’t worked out so well, but that’s what hedges are suppose to do (or at least that’s what I tell myself).  As a result I have some cash in my IRA account sitting in a money market fund.  Inflation despite relative benign numbers as of late, remains a substantial risk especially if the Fed continues to cut rates.  By putting my money into TIPS, I can protect myself a bit from both inflation risks, and interest rate cuts.  TIPS like regular bonds appreciate when interest rates go down.  Given that there’s a decent probability that rates which might lead to higher inflation, TIPS are an excellent way to take advantage ever so slightly both of those risks.

Investing in TIPS is not a no brainer though.  There are many people including myself who are skeptical of the use of the CPI (consumer price index) as the best gauge of inflation which happens to be the index that TIPS use.   I would also be very hesitant to invest in TIPS in any kind of taxable account or as a primary investment strategy.  In taxable account, taxes eat away at the inflation protection.  The CPI could be 10% and the TIPS adjusts by 10% just to keep up, yet after taxes of 30%, the investor is down after adjusting for inflation.  Also for most individual investors the best way to invest in TIPS are through bond funds such as VIPSX (Vanguard), FINPX (Fidelity), and PRRIX (Pimco).  I actually haven’t done much research into the different funds as I make my inflation protected investments through my 401k which only offers one option, a flavor of the Vanguard fund.