Are Currencies the Holy Grail in Diversification?

Low correlation and relatively expensive, these assets may add efficiency to clients' portfolios

This news originally appeared on WealthManagerWeb on 11/11/09. If you believe that allocation to non-correlative assets to diversify portfolios is the Holy Grail of better risk-adjusted returns, you may find this interesting. There is a pair of currency funds that may help wealth managers achieve that in clients' portfolios.

Over the past couple of years, it has been difficult to find assets that don't correlate almost perfectly with typical portfolio asset allocations--without incurring the greater costs of buying hedge funds, especially in times of dire market distress when the lock-ups would be a negative attribute for hedge funds. And of course, with the high investment minimums and investor qualification needed, hedge funds have been beyond the reach of many clients. While hedge fund-of-funds are an option, there's that extra layer of costs. So what's a wealth manager to do?

A possibility is to add an allocation to a basket of currencies. One way to do that is through international bonds denominated in the local currencies; another is to use futures. A third option is to have an investment bank "put together a swap--but there are layers of fees," and the additional element of the "counterparty risk of the investment bank," according to Axel Merk, president of Merk Funds, part of Merk Investments, in Palo Alto, California.

Merk has two funds that could be used to accomplish an allocation to currencies: Merk Hard Currency Fund (MERKX), and Merk Absolute Return Currency Fund (MABFX). They employ very different strategies. The Hard Currency Fund, launched in May, 2005, is a "special case international bond fund," that can give clients, "international exposure without equity risk, and less credit risk," says Merk, who sat down with Wealth Manager for an exclusive interview on November 10. This fund seeks to "profit from the decline in the dollar." Through the bonds, which are denominated in the local currencies, and are of very "short duration," the fund essentially holds a basket of currencies. Merk looks at this fund as a "diversified approach to something as mundane as cash."

Merk takes a macro approach to selecting which bonds, and therefore which underlying currencies, to invest in. He focuses on the central banks that are making moves that encourage stronger currencies because the central banks that "focus on price stability will have stronger currencies." For example, "the Yen can be strong when [Japan's] economy is doing poorly," Merk explains, adding, "Japan can have a strong currency because they finance current accounts domestically." Conversely, the "U.S. needs growth to have a strong currency because of the current account deficit."

Ultimately, this is a way of playing where the big dogs are: "Central banks are holding baskets of currencies," Merk says. "If Central banks are doing it why wouldn't you want to do that as an investor?" And it's a way of adding a relatively inexpensive low-correlation asset.

The Merk Hard Currency Fund correlates to the inverse of the Dollar Index, (Bloomberg ticker DXY Curncy), "which tracks dollar strength," according to an email from Kieran Osborne, Co-Portfolio Manager at Merk Investments. The "inverse of the Dollar Index, tracks dollar weakness," he adds. The correlation of the inverse of the Dollar Index against the DJIA is -0.057, and against the S&P 500, it is -0.042, for the period of Dec. 31, 1009 to September 30, 2009, according to Osborne.

The Absolute Return Currency Fund, launched in September, has a totally different perspective and strategy. First, the fund is a pure currency play, going long or short using forward currency contracts, collateralized with U.S. T-bills. That way the fund can go, relatively inexpensively, long or short by pairing the U.S. dollar versus another currency. The fund seeks to profit whether the dollar is strong or weak--"independent of market prevailing conditions, without leverage, and without a lot of counterparty risk," Merk notes. The fund has, long term, "almost zero correlation to," standard asset classes in the portfolio.

Neither fund typically uses leverage; they have an expense ratio of about 1.3%--they are not index finds--but of course, that's the whole point.

Kate McBride is editor in chief of WealthManagerWeb and a member of The Committee for the Fiduciary Standard.
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