Commentary

The rising concern about the United States dollar's value has become impossible to miss. Gold has risen above $1,000 an ounce; investors desperate for energy exposure have kept natural gas in steep contango all year; and every other day we seem to get a call or an e-mail asking about foreign currency funds such as PowerShares DB US Dollar Bearish.

We understand the fretting. Various emergency measures over the past year pumped enormous quantities of dollars into the financial system, and they're more likely to cause inflation now that we no longer have panicked investors worldwide clamoring for the safe harbor of the dollar. Chinese central bank officials dropped hints for much of the past year that they would like to diversify away from Treasury bonds, and recent large investments in commodities and mines show they might be serious this time. Even the new Japanese Minister of Finance made comments that implied Japan may no longer suppress its currency against the dollar to support exporters. Without the artificial support of the major East Asian currencies, we couldn't say how far the dollar might fall.

This news looks worrying, but we are not giving up on the greenback yet. The Federal Reserve has managed to shrink overall money supply through most of 2009 by withdrawing some of the financial supports and pulling back freshly minted dollars that merely sat in banks' vaults to ward off panic. No matter what Chinese officials say, with $2 trillion and counting in reserves, they simply have to keep buying Treasury bonds. There's no other market big enough to meet their incredible investment needs without severely distorting prices. Chinese imports of copper and other industrial commodities have already fallen as prices soared in the past few months. As for the Japanese Minister, he has already tried to take back his comments, saying instead that he was merely content with current exchange rates.

We believe that the dollar will likely depreciate over the next decade relative to other currencies, as the euro and major emerging currencies replace some of the massive Treasury bond reserves held by central banks worldwide. However, we feel that the depreciation is likely to be fairly mild and could take years to finalize. Investing in the fall of the dollar could easily be a volatile bet that pays off too little, too late. In fact, after its recent tear downward, we would not be surprised if the buck bounces back slightly in the near term as stock markets cool down their remarkable rise.

All those caveats aside, we decided to draw up a model portfolio for anyone with a more bearish opinion on the world's biggest currency. When we kept hearing questions about foreign currency funds such as UDN or the WisdomTree and CurrencyShares lineups, we worried that investors seeking to profit from a dollar downturn might be barking up the wrong tree. These funds, although the most direct bets against the dollar in the ETF universe, are merely cash accounts with an overlay of foreign currency exposure. They will not provide much economic return aside from changes in exchange rate and do little good as a small supplementary holding in a typical portfolio. So what if your Chinese yuan fund goes up 15% if your larger U.S. bond and equity holdings have collapsed?

Instead, investors should change the weightings of their entire portfolio to move away from the dollar while maintaining similar overall exposures to stocks and longer-term bonds. Currency funds have their place, but mostly as a replacement for cash that would otherwise be held in a U.S. dollar-denominated money market fund. Moving more money into foreign stocks and foreign bonds will position a portfolio to soar if the dollar falls but not sacrifice the returns generated by these risky assets even if the greenback remains solid.

Our Dollar-Proof portfolio still contains a hefty 58% allocation to global equities. However, we cut down on our U.S. equity holdings relative to the Hands-Free model portfolio from ourETFInvestor newsletter and consolidated them into Vanguard Total Market ETF. This eliminates our overweighting of small caps, as they lack the foreign revenues that could cushion or even buttress U.S. large caps in case of a dollar decline, and they look a bit overvalued at the moment anyway. After the incredible returns of emerging-markets stocks in 2009, we also felt no need to overweight them relative to other foreign markets. Thus the two Vanguard ETFs based on the cap-weighted FTSE All-World ex-US indexes worked beautifully to fill out our sizable foreign equity stakes. We substantially overweighted international small-cap stocks, as they do the least business in U.S. dollars, and we still love the long-term prospects of emerging-markets small caps.

Our fixed-income allocation got cut down to 20% from 25% in our Hands-Free portfolio and is split between domestic and international inflation-protected securities. Because a falling dollar probably means that central banks are dumping U.S. bonds and yields are rising (both due to inflation and higher real yields), we kept our TIPS allocation in a short-duration fund. We would have loved to add some foreign credit bonds to our portfolio, but that is unfortunately not possible with the ETFs available today. Instead, we shifted that extra 5% into our cash allocation, which we split between two currency ETFs that together cover a range of the biggest global currencies including the euro, yen, Canadian dollar, Chinese yuan, and Brazilian real.

Finally, we put a larger investment into commodity-related securities than our Hands-Free portfolio and took solely long positions to capture all of the gains if the dollar depreciates relative to hard assets. Gold trades for lofty prices, but it will certainly benefit if the dollar falls further, so we propose a 5% position in this classic hedge. Commodity ETFs in other sectors cannot physically hold the underlying, which makes them vulnerable to the nearly universal state of contango that has hurt so many commodity futures funds this year. We prefer to capture energy prices using an investment in smaller oil and gas producers whose higher operating leverage makes them especially sensitive to rising spot and futures prices. As for agricultural products, we decided to invest directly in the undervalued market leader whose genetically modified crops will provide the higher yields demanded by farmers as prices rise. We suggest a smaller 2% stake due to the single-stock risk, but the high quality of Monsanto and its apparent undervaluation provides a decent margin of safety.

To be perfectly fair, this model portfolio is not actually immune to a falling dollar. It's more of a dollar-dulling than a dollar-proofing. It would be unwise to move entirely out of the dollar and into protective assets such as commodities and short-term bonds. If the bet turns out incorrect, such a skewed portfolio would miss out on considerable potential gains while also opening itself up to severe losses from falling gold and energy prices. Without tremendous certainty about an impending collapse, we believe investors should stay quite diversified and merely tilt away from worrisome exposures.

Click here to view the table. http://news.morningstar.com/articlenet/article.aspx?id=314413

Bradley Kay does not own shares in any of the securities mentioned above.

Disclosure: Morningstar licenses its indexes to certain ETF and ETN providers, including Barclays Global Investors (BGI), Claymore Securities, First Trust, and ELEMENTS, for use in exchange-traded funds and notes. These ETFs and ETNs are not sponsored, issued, or sold by Morningstar. Morningstar does not make any representation regarding the advisability of investing in ETFs or ETNs that are based on Morningstar indexes.