Foreign exchange can be a quandary for investment strategy. Currencies generally suffer an expected return of zero in the long run, a shortcoming that raises questions about the strategic value of the asset class. But for shorter periods, forex risk can enhance portfolio diversification and boost risk-adjusted performance.
Whatever their charms, currencies in pure form traditionally have had limited appeal for the wealth management business. To the extent that investment strategy for individual clients has embraced forex, it's usually tapped indirectly--almost as an afterthought--through allocations to unhedged positions in foreign stocks and bonds.
Actually, it has been easy for U.S. investors to discount the currency factor, if not ignore it completely. Until recently, allocating capital to forex proper meant using derivatives or buying currencies directly or through a proxy, such as short-term bonds based in euros or yen, for instance. Neither approach has been popular with wealth managers in this country, in part because there's been only a modest incentive for diversifying out of the dollar. For eight years through 2001, the greenback strengthened against the world's major currencies, and for roughly 10 years before that the dollar was relatively stable, as the chart on page 58 shows. No wonder that the case for adding forex risk to portfolios in those years was a hard sell to U.S. investors.
"I can think back to a time in the late 1990s when the dollar was all powerful, and everybody at that time--or a large majority of investors--was essentially dismissing the idea of having any assets outside the dollar," recalls Kunal Kapoor, chief investment officer at Morningstar Investment Services. "Fast forward to today, and you have the reverse going on."
Another reason that American investors are taking a fresh look at forex is because diversifying out of the greenback is easier, thanks to a growing list of currency-focused ETFs and mutual funds. More importantly, there's a growing concern that the buck is susceptible to devaluation in the years ahead, a suspicion that's been fueled by the dollar's slump last year as well as various macroeconomic warning signs such as a widening U.S. trade deficit and a decline in individuals' savings rates in America relative to other countries.
For whatever the reasons, forex is attracting attention as a strategic holding. "Currency risk certainly intrigues us," says Jerry Miccolis, senior financial advisor at Brinton Eaton Wealth Advisors in Morristown, N.J. "A currency play is something we've discussed and debated," although the firm continues to favor unhedged positions in foreign stocks and bonds for owning currencies.
At Main Management LLC in San Francisco, portfolios for high-net-worth clients may hold as much as 5 percent in a currency ETF that specializes in the so-called carry trade--holding currencies in countries with relatively high short-term interest rates and shorting the lower-yielding ones. Diversification is the selling point, says Kim Arthur, the firm's CEO. He expects that PowerShares DB G10 Currency Harvest ETF (DBV) will earn equity-like returns and post low correlations with the stock market over time.
Currencies were added to the strategic mix three years ago for individual clients of Lehman Brothers, reports Aaron Gurwitz, managing director of the portfolio advisory group at the firm's private investment management division in New York. "Most prospective and current clients have a larger proportion of their investment portfolios denominated in U.S. dollars than we think advisable," he says. "Generally, we recommend that U.S.-dollar-based clients have at least 25 percent of their investments in vehicles not denominated in U.S. dollars."
Gurwitz favors several strategies for accessing forex, ranging from unhedged foreign equities to structured notes that are indexed to the performance of one or more currencies. Lehman also uses a privately managed fund run by Samson Capital Management in New York. Samson's currency program seeks to outperform the inverse of the U.S. Dollar index, a popular benchmark of the greenback as measured by the leading foreign currencies. The fund is notable because most of its investors are high-net-worth individuals.
The dollar's decline of late has aided the tactical allure of currency funds, but is there a case for a dedicated currency allocation as a long-term proposition? Yes, thanks to the evolution of the global economy, says Jonathan Lewis, a portfolio manager at Samson who chairs the firm's investment committee. For decades after World War II, the United States was the undisputed "economic hegemon," Lewis explains. Standing atop the world economy simplified the investment outlook for several generations of Americans. "One of the benefits was the wonderful experience of not having to worry about the rest of the world. The thinking was that you could be fully invested in U.S. dollar-denominated assets and capture the lion's share of the world's best opportunities."
In 2008, fewer investment strategists see America's opportunities in the global economy in such starkly positive terms. To be sure, the U.S. remains the planet's largest economy and by several crucial measures remains an attractive destination for capital investment. What's changed has less to do with the decline of America, real or perceived, and more with the rise of competition--particularly in the developing world.
Lewis emphasizes that America represents a large, but declining piece of an expanding investment pie. "The U.S. economy, while important and dominant, doesn't reflect the opportunity set of all the best possible choices," he says. As globalization expands its reach and influence, foreign assets should be reflected in investment portfolios. "If more and more of your basket of goods is coming from other places, you should, as a conservative investor, have some exposure to those places [for reasons that go] beyond whether or not you have an equity market outlook in those places."
The academic argument for always holding some foreign currency risk in investment portfolios dates to at least 1989 and Fischer Black's "Universal Hedging: Optimizing Currency Risk and Reward in International Equity Portfolios" in the Financial Analysts Journal. Black offers a simple formula for estimating how much to hedge foreign currency exposure. The formula has three inputs, each calculated from the average across individual countries for the attached formulas
The result produces what Black identifies as the "optimal hedge ratio," or "the fraction of your foreign investments you should hedge." The paper concludes that all investors, regardless of country, should hedge only a portion of their foreign investments. Why not hedge away forex completely? Because "taking some currency risk" boosts a portfolio's expected returns, he advises.
The challenge is deciding how much currency exposure is optimal. The answer partly relies on the risk and return objectives of the investor. The markets are a factor, too. Returns and volatilities fluctuate over time, and so Black's hedging ratio varies, depending on the historical period chosen for analysis. In his paper, Black cites two examples drawn from slightly different stretches of market data in the 1980s. He writes that the two results for the recommended portion of a portfolio to hedge dollar exposure were 30 percent and 73 percent. That leads Black to warn, "Straight historical averages vary too much to serve as useful inputs for the formula. Estimates of long-run average values are better."
Estimating future input values is necessarily subjective, but the larger message is that no investment portfolio should be 100 percent hedged against forex risk. The reason is due to the fact that the rise of one currency relative to another is always larger in percentage terms than the percentage depreciation in the other. That leads to the conclusion that investors in any two currencies, for instance, can boost expected returns by holding both currencies. The phenomenon--known as Siegel's paradox--was first noted more than 30 years ago by economist Jeremy Siegel ("Risk, Interest Rates, and Forward Exchange," Quarterly Journal of Economics, May 1972).
While there's an academic case for always holding some degree of forex risk, most wealth managers prefer tapping currencies through unhedged foreign stocks and bonds. One motivation is efficiency. A 15 percent allocation to currencies proper, for instance, means pulling assets from somewhere else. "Whatever assets you use to place a currency bet, you don't have to invest elsewhere," says Brinton Eaton's Miccolis. Alternatively, investing in unhedged foreign stocks or bonds delivers a currency embedded securities stake, effectively providing a two-for-one deal.
"We get our currency diversification straight through equity index funds that we use," Rick Ferri, founder and CEO of Portfolio Solutions LLC in Troy, Mich., tells Wealth Manager. "Direct [currency] overlays are fine if you're managing very large sums of money." Short of super wealthy individuals or institutional portfolios, currency diversification by way of unhedged stock and bond funds is the better choice, he asserts.
Echoing Miccolis' point, Ferri notes that pure currency allocations, and so-called alternative strategies in general, may incur an opportunity cost in the long run. Funding an allocation in currencies by taking it out of equities may look attractive on a short-term basis. "Yes, you may lower the overall risk of your portfolio," he concedes, "but there's a very good likelihood that you'll also lower the return."
Nonetheless, there's a bull market in bringing exotic betas and alternative strategies to the masses via publicly traded funds. But in his recently published The ETF Book (Wiley, 2007), Ferri counsels that there's a risk that the expected diversification benefits may be offset by fees, inflation and a lower tax efficiency. Regardless, innovation in ETFs rolls on. "Hopefully," Ferri writes, "the fees to invest in those products will be low enough so that they benefit buy-and-hold portfolios as well as an active trading portfolio."
James Picerno (firstname.lastname@example.org) is senior writer at Wealth Manager.