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Opportunity Classes: Three Crucial Factors for Currency Management in Your Portfolio

September 7, 2011
by Jack Reynolds

This article is the last in a six part series about Opportunity Classes, an innovative way to structure your investment strategy.  It focuses specifically on the intriguing and important contribution of currency management to structuring a successful portfolio strategy. Currency is an issue that too many investors simply elect to ignore because it is outside of their comfort zone. You will see, however, that it need not be mysterious, that it is within you control, and that managing it can improve your investment results. I will strive to focus your attention on three crucial currency factors:

  1. Currency Matters And It Is Within Your Control
  2. A Consistent Currency Management Policy Is Your Best Choice
  3. For Advanced Investors: Currency As An Asset Class

1.       Currency Matters And It Is Within Your Control

When I speak with clients about currency management, we typically talk in terms of the currency they use to support their lifestyle, pay their bills and taxes, make gifts and transfer wealth. That currency is referred to as their home currency. While there are a great many currencies in the world, there are four dominant global currencies: the euro, the British pound, Japanese yen and the US dollar. (In time, the Chinese yuan or renminbi will be added to that list, but it is not yet an international currency that is freely tradable.)

Currency and International Investing

In thinking about currency and international investing, we need to put on a different hat. From an economic perspective, investors typically think that a strong home currency is a good thing.  A strong home currency makes imports appear inexpensive, and when travelling to other counties, a strong home currency typically goes a long way. A less well appreciated fact is that a weak home currency facilitates exports and can be a great boon to investments made in countries with strong currencies.  Why?  As your home currency falls in value, your investments made in major foreign currencies rise in value.  Investing in assets denominated in strong foreign currencies when you have a falling home currency is like riding a bike with the wind at your back – you don’t need to pedal harder to go faster!

Currency Fluctuations

So far, investing in assets denominated in foreign currencies sounds easy.  This is especially true if your home currency is the US dollar.  The US dollar has generally been in decline for some time and is likely to continue its downward trend. The problem is that investors cannot reliably predict currency relationships over the short-term or even the next year. Currency moves (or fluctuations) tend to be so volatile, sporadic and unpredictable that even if a long-term trend persists, the variability around that trend can disrupt your entire investment strategy.

For example, if you look at the history of the relationship between the US dollar and the euro you will observe considerable volatility. Looking back over the last ten-plus years, the euro/dollar ratio has ranged from a low of 0.85 in June, 2001 to a high of 1.6 in July, 2008. Simply eyeball the number of times that the direction or short-term trend has changed and you will get a sense of their volatile relationship.  (Here is a link to an easy to use website where you can create your own graph for any time period you wish.)

There is nothing wrong with volatility — as long as there is reasonable compensation for taking on that element of risk. The rub is that currency fluctuations are considered uncompensated risk because they are a zero sum game.  When one currency goes up another one goes down.  Further, the long-term expected return for all currency owners as a group is zero; and taking on volatility risk with an expected return of zero is generally not wise.

Currency fluctuations are especially problematic for defensive assets denominated in foreign currencies.  Defensive assets, such as cash, bonds and hedge funds, are intended to provide stable, possibly modest, returns for your portfolio and to reduce its overall volatility.  With bonds, for example, you accept some measure of risk in return for its coupon payment and return of principal. With equities, you embrace an element of risk hoping that the company will prosper and the value of its stock will rise.  With hedge funds you accept a reduced return with the expectation of reduced volatility achieved through the manager’s use of hedging tools. When you invest in non-home currency bonds, equities and hedge funds you introduce an element of uncompensated volatility. In less defensive asset classes you may be willing to accept that volatility because of their higher expected return.

Formulating an Approach to Currency

I do not suggest avoiding defensive assets denominated in non-home currencies. I am simply recommending you manage the currency risk, especially for defensive assets such as cash, bonds and hedge funds.

Managing currency risk is also within your control if you invest in mutual funds.  Many mutual funds and SICAVs (the European equivalent) invest in assets outside your home currency and offer share classes that are hedged back to your home currency.  (This assumes that your home currency is one of the four major currencies). Hedging non-home currency exposures (including defensive assets) back to you home currency eliminates unwanted and uncompensated risk from your portfolio. Once hedged, currency moves will no longer help or harm that portion of your portfolio. If you are using a separate account vs. a mutual fund, the manager can hedge your investment back to your home currency.

If your mutual funds do not offer a currency hedged share class, your separate account manager does not provide currency hedging, you want to currency hedge your hedge fund portfolio, or your home currency is not one of the major currencies, your private banker can help you build a procedure for hedging your non-home currency exposures back to your home currency. This sort of hedging is done in the currency futures markets which are amongst the largest, most liquid, efficient, and least costly markets in the world.

2.       A Consistent Currency Management Policy Is Your Best Choice

I advocate for having a consistent currency management policy. I see it as a long-term coherent strategy, not as a tactical issue. That is, I do not advise attempting to elect when to employ, and when not to employ, currency hedging based on your fluctuating views (or your adviser’s short-term views) about the trends in various currency pairs. The chances are very high that you will zig exactly when you should have zagged and vice versa. I advocate developing a currency hedging strategy by asset class with your key advisors and then sticking with it for a long time.

If I have convinced you that currency management is an important part of your portfolio strategy, then where should you begin?  Start with the defensive assets in your portfolio that I referred to above: cash, fixed income and hedge funds. Currency hedging these defensive asset classes is important because their returns can be overwhelmed by currency moves, thus compromising their defensive contribution to your portfolio.

You may choose not to currency hedge your less defensive, more growth-oriented, traditional marketable equities and non-marketable alternative assets (e.g., buyout funds, venture capital, real estate and natural resources) due to their higher expected returns.  Furthermore, I said that currency hedging is simple and inexpensive for professional investment managers when hedging among the four major currencies.  However, that is not necessarily the case with more exotic currencies. You may want to embrace currency risk for some exotic currencies while hedging others.

3.       For Advanced Investors: Currency As An Asset Class

Treating currency as an asset class is a controversial subject. There are those who argue that currency should be treated as an asset class, right up there with cash, fixed income, traditional equities, etc., and should be managed as such.  Then there are those who say that currency is not an asset class precisely because it is a zero sum game with no expected return.

In my view, currency trading is rather like managed futures. The investor is not investing in an asset class from which they hope to extract both beta (the expected return of an asset class) and alpha (manager value added). Rather, one invests with a trader based on her/his unique skills and insights about the markets in which they are trading. I am slow to embrace having a fund or manager dedicated to managing currency as an asset class. Currency funds, traders and managers should only be engaged by large and highly sophisticated investors. To the extent that an investor embarks on this path it should be an adjunct to the traditional currency management discussed above and not a replacement for it.

Two Letters to the Editor

“Your last newsletter addressing the use of debt by private investors was excellent.” Retired senior private banker, Chicago.

“For my clients I find it useful to maintain a line of credit (or collateralized line against all or portion of investment assets) for a number of reasons.  A recent example is when a client was selling one home and purchasing another, we used her line to bridge the gap between settlements.  She avoided the cost and time of setting up a second mortgage.

“One thing I hesitate to suggest, however, is to use the credit to purchase more like securities.  We are not in the business to speculate with our client’s wealth so this usage, although attractive to some, would not be a reason we would typically use a line.” Geoffry A. Juviler, Managing Director, Boston Financial Management, Inc.

A Personal Request to Help a Close Family Recover from Hurricane Irene

I am sure that you are fully familiar with the damage that Hurricane Irene has wreaked in Vermont. I am using ChipIn to help raise money to assist one family who lost their home to Irene. Their need is compelling, and I encourage you to join me in helping this diligent, hardworking couple recover from Hurricane Irene. Just click on ChipIn and you will see their background. I have already wired them a meaningful four-figure gift. You can make a contribution via ChipIn or send them a check. Thank you for your generosity and kindness.

-Jack