INVESTMENT OUTLOOK: HOW TO GET AHEAD : INVESTMENT STRATEGIES : CASHING IN ON CURRENCY : Foreign-Denominated Funds Reduce Risk of Speculating on Exchange Rates

The dollar has fluctuated wildly in the 1980s, creating the potential for big gains as well as spectacular losses for hardy souls willing to play the foreign currency markets.

The dollar soared to heights of more than 270 Japanese yen and 3.3 West German marks earlier this decade, only to drop, erratically, to current levels of around 121.6 yen and 1.7 marks.

For people willing to gamble on currency fluctuations, however, the investment choices are limited. One of the standard methods, purchasing currency futures or currency options, is probably too risky for all but the most sophisticated investors. At the same time, buying and simply holding foreign currency or maintaining foreign bank accounts is often difficult or simply not worthwhile for small investors.

But there is an investment that is less speculative than futures and options and also pays interest: mutual funds and unit investment trusts that invest in foreign-denominated securities, especially bonds. Anne Mills, an analyst at Shearson Lehman Hutton, describes the foreign bond funds as a way to take advantage of potential declines in the dollar without risking the total investment.

Several major investment firms, including such big names as Shearson and Merrill Lynch, offer a variety of mutual funds or unit trusts that invest in foreign bonds denominated in foreign currencies such as Australian dollars, Japanese yen, British sterling, West German marks and Canadian dollars, as well as European Currency Units. The minimum initial investment varies from as little as $100 to $1,000 or more.

The advantage of these is that the bonds pay interest--in the case of Australia, New Zealand and, lately, the United Kingdom, high interest--providing a return that would at least partly offset an unexpected decline in the foreign currency’s value. On the other hand, any interest earned on the bonds would add to the gain from a favorable movement of the foreign currency against the dollar. Indeed, some investors have poured money into certain funds simply because of the higher interest rate, ignoring the substantial exchange rate risk.

As the dollar has slid in recent years, some of the funds have provided impressive returns. A U.S. investor holding a mix of Australian government bonds for the 12 months ending Oct. 31 would have had a total return, including interest and gain on currency exchange, of 43.85%.

But be careful: The experts warn that the funds generally make sense only if one expects the dollar to fall, which makes foreign bonds more valuable to U.S. investors. If the recent trend is reversed and the dollar rises, then the value of many foreign securities drop in terms of the dollar.

Although the dollar already has declined significantly in recent months, most economists and currency experts expect it to slip more next year. Reasons include foreign concern about America’s huge budget deficit and the belief that, despite denials, the Bush Administration may be willing to let the dollar slide lower to help ease the trade deficit.

If these expectations are correct, now is a good time to invest. But the economists caution that with the start of a new Administration in Washington and uncertainty over the direction of the U.S. economy, the prognosis is far from clear.

The safer, broad-based funds typically invest in a diversified variety of foreign bonds, mainly government securities but also some corporate bonds.

David B. Walter, vice president and senior portfolio manager at Merrill Lynch Asset Management, recommends long-term investments in well-diversified funds. “We tend to believe that a well-diversified portfolio will prevent whipsaws in any particular currency,” he said.

One of the major funds, the T. Rowe Price International Bond Fund, had a total return of 27.2% for 1987. But for the 12 months ending Oct. 31, the return is down substantially, to 8.0% for the period, because of the dollar’s temporary rise earlier this year.

The Bailard, Biehl & Kaiser money management firm in San Francisco is projecting returns of 8.2% for international bonds in the next 12 months and of 13.8% over the next four years.

Experts advise that not all foreign currencies fluctuate in the same way in reaction to U.S. economic news, meaning that at different times investors might want to invest in one currency but not others. The yen and the West German mark tend to go up or down in direct relation to U.S. economic news, such as the changes in the U.S. trade deficit or interest rates. Thus, although West German and Japanese bonds pay significantly less interest than comparable U.S. securities, they have the advantage of responding more or less predictably to U.S. economic developments. If the dollar goes down, they normally rise.

But lower interest rates in those countries mean that the dollar must depreciate substantially to make up for the additional interest one would have earned if the investor had put his money into U.S. certificates of deposit or bonds, notes David Schoenthal at Shearson.

Currencies such as the Australian dollar and the British pound tend to vary independently. For example, Mills said, the Australian dollar lately tends to swing with world commodity prices because that country’s economy is tied to basic agricultural commodities and other natural resources.

If the dollar is going up against major currencies such as the yen and mark, the only practical way to profit from its ascent would be risky investments in options or even riskier futures. Investors would be better off holding most of their assets in dollars, the Merrill Lynch fund manager says.

As to other methods of profiting from a potential decline in the dollar, simply buying and holding foreign currency is one method, but exchange fees charged by dealers eat into any profit and no interest is earned. Along with the bureaucratic difficulties involved in setting up foreign bank accounts, exchange fees also apply and any interest earned often is eaten up by a variety of administrative expenses and, sometimes, foreign taxes.