Foreign exchange can be a quandaryfor investment strategy. Currenciesgenerally suffer an expected return of zeroin the long run, a shortcoming that raisesquestions about the strategic value of theasset class. But for shorter periods, forexrisk can enhance portfolio diversificationand boost risk-adjusted performance.Whatever their charms, currencies inpure form traditionally have had limitedappeal for the wealth management business.To the extent that investment strategyfor individual clients has embracedforex, it’s usually tapped indirectly—almostas an afterthought—through allocationsto unhedged positions in foreignstocks and bonds.
Actually, it has been easy for U.S. investorsto discount the currency factor, if notignore it completely. Until recently, allocatingcapital to forex proper meant usingderivatives or buying currencies directlyor through a proxy, such as short-termbonds based in euros or yen, for instance.Neither approach has been popular withwealth managers in this country, in partbecause there’s been only a modest incentivefor diversifying out of the dollar. Foreight years through 2001, the greenbackstrengthened against the world’s majorcurrencies, and for roughly 10 years beforethat the dollar was relatively stable,as the Chart below shows. No wonderthat the case for adding forex risk toportfolios in those years was a hard sell toU.S. investors.
Actually, it has been easy for U.S. investorsto discount the currency factor, if notignore it completely. Until recently, allocatingcapital to forex proper meant usingderivatives or buying currencies directlyor through a proxy, such as short-termbonds based in euros or yen, for instance.Neither approach has been popular withwealth managers in this country, in partbecause there’s been only a modest incentivefor diversifying out of the dollar. Foreight years through 2001, the greenbackstrengthened against the world’s majorcurrencies, and for roughly 10 years beforethat the dollar was relatively stable,as the Chart below shows. No wonderthat the case for adding forex risk toportfolios in those years was a hard sell toU.S. investors.
Foreign exchange can be a quandaryfor investment strategy. Currenciesgenerally suffer an expected return of zeroin the long run, a shortcoming that raisesquestions about the strategic value of theasset class. But for shorter periods, forexrisk can enhance portfolio diversificationand boost risk-adjusted performance.Whatever their charms, currencies inpure form traditionally have had limitedappeal for the wealth management business.To the extent that investment strategyfor individual clients has embracedforex, it’s usually tapped indirectly—almostas an afterthought—through allocationsto unhedged positions in foreignstocks and bonds.
Actually, it has been easy for U.S. investorsto discount the currency factor, if notignore it completely. Until recently, allocatingcapital to forex proper meant usingderivatives or buying currencies directlyor through a proxy, such as short-termbonds based in euros or yen, for instance.Neither approach has been popular withwealth managers in this country, in partbecause there’s been only a modest incentivefor diversifying out of the dollar. Foreight years through 2001, the greenbackstrengthened against the world’s majorcurrencies, and for roughly 10 years beforethat the dollar was relatively stable,as the Chart below shows. No wonderthat the case for adding forex risk toportfolios in those years was a hard sell toU.S. investors.
“I can think back to a time in the late1990s when the dollar was all powerful, andeverybody at that time—or a large majorityof investors—was essentially dismissingthe idea of having any assets outside thedollar,” recalls Kunal Kapoor, chief investmentofficer at Morningstar InvestmentServices. “Fast forward to today, and youhave the reverse going on.”One reason that American investors aretaking a fresh look at forex is because diversifyingout of the greenback is easier,thanks to a growing list of currency-focusedETFs and mutual funds. More importantly,there’s a growing concern thatthe buck is susceptible to devaluation inthe years ahead, a suspicion that’s been fueledby the dollar’s slump last year as wellas various macroeconomic warning signssuch as a widening U.S. trade deficit anda decline in individuals’ savings rates inAmerica relative to other countries.
Whatever the reasons, forex is attractingattention as a strategic holding.“Currency risk certainly intrigues us,”says Jerry Miccolis, senior financial advisor at BrintonEaton Wealth Advisors in Morristown,N.J. “A currency play is something we’vediscussed and debated,” although thefirm continues to favor unhedged positionsin foreign stocks and bonds for owning currencies.At Main Management LLC in San Francisco,portfolios for high-net-worth clientsmay hold as much as 5 percent in a currencyETF that specializes in the so-calledcarry trade—holding currencies in countrieswith relatively high short-term interestrates and shorting the lower-yieldingones. Diversification is the selling point,says Kim Arthur, the firm’s CEO. He expectsthat PowerShares DB G10 CurrencyHarvest ETF (DBV) will earn equity-like returnsand post low correlations with thestock market over time.
Currencies were added to the strategicmix three years ago for individual clientsof Lehman Brothers, reports Aaron Gurwitz,managing director of the portfolioadvisory group at the firm’s private investmentmanagement division in NewYork. “Most prospective and current clientshave a larger proportion of their investmentportfolios denominated in U.S.dollars than we think advisable,” he says.“Generally, we recommend that U.S.-dollar-based clients have at least 25 percentof their investments in vehicles not denominatedin U.S. dollars.”
Gurwitz favors several strategies foraccessing forex, ranging from unhedgedforeign equities to structured notes thatare indexed to the performance of one ormore currencies. Lehman also uses a privatelymanaged fund run by Samson CapitalManagement in New York. Samson’scurrency program seeks to outperform theinverse of the U.S. Dollar index, a popularbenchmark of the greenback as measuredby the leading foreign currencies. The fundis notable because most of its investorsare high-net-worth individuals.
The dollar’s decline of late has aidedthe tactical allure of currency funds, butis there a case for a dedicated currencyallocation as a long-term proposition?Yes, thanks to the evolution of the globaleconomy, says Jonathan Lewis, a portfoliomanager at Samson who chairs the firm’sinvestment committee. For decades afterWorld War II, the United States was the undisputed“economic hegemon,” Lewis explains.Standing atop the world economysimplified the investment outlook for severalgenerations of Americans. “One of thebenefits was the wonderful experience ofnot having to worry about the rest of theworld. The thinking was that you could befully invested in U.S. dollar-denominatedassets and capture the lion’s share of theworld’s best opportunities.”
In 2008, fewer investment strategistssee America’s opportunities in the globaleconomy in such starkly positive terms. Tobe sure, the U.S. remains the planet’s largesteconomy and by several crucial measuresremains an attractive destinationfor capital investment. What’s changedhas less to do with the decline of America,real or perceived, and more with the rise ofcompetition—particularly in the developingworld.
Lewis emphasizes that America representsa large, but declining piece ofan expanding investment pie. “The U.S.economy, while important and dominant,doesn’t reflect the opportunity set of allthe best possible choices,” he says. Asglobalization expands its reach and influence,foreign assets should be reflectedin investment portfolios. “If more and more of yourbasket of goods is coming from other places, youshould, as a conservative investor, have some exposureto those places [for reasons that go] beyondwhether or not you have an equity market outlookin those places.”
The academic argument for always holding someforeign currency risk in investment portfoliosdates to at least 1989 and FischerBlack’s “Universal Hedging: OptimizingCurrency Risk and Reward in InternationalEquity Portfolios” in the Financial AnalystsJournal. Black offers a simple formula forestimating how much to hedge foreigncurrency exposure. The formula has threeinputs, each calculated from the averageacross individual countries for
* expected excess return on theworld market portfolio (R)
* volatility of the world marketportfolio (V)
* the average across all pairs ofcountries of exchange ratevolatility (E)
The data points are then analyzed as
R - V^2
Actually, it has been easy for U.S. investorsto discount the currency factor, if notignore it completely. Until recently, allocatingcapital to forex proper meant usingderivatives or buying currencies directlyor through a proxy, such as short-termbonds based in euros or yen, for instance.Neither approach has been popular withwealth managers in this country, in partbecause there’s been only a modest incentivefor diversifying out of the dollar. Foreight years through 2001, the greenbackstrengthened against the world’s majorcurrencies, and for roughly 10 years beforethat the dollar was relatively stable,as the Chart below shows. No wonderthat the case for adding forex risk toportfolios in those years was a hard sell toU.S. investors.
“I can think back to a time in the late1990s when the dollar was all powerful, andeverybody at that time—or a large majorityof investors—was essentially dismissingthe idea of having any assets outside thedollar,” recalls Kunal Kapoor, chief investmentofficer at Morningstar InvestmentServices. “Fast forward to today, and youhave the reverse going on.”One reason that American investors aretaking a fresh look at forex is because diversifyingout of the greenback is easier,thanks to a growing list of currency-focusedETFs and mutual funds. More importantly,there’s a growing concern thatthe buck is susceptible to devaluation inthe years ahead, a suspicion that’s been fueledby the dollar’s slump last year as wellas various macroeconomic warning signssuch as a widening U.S. trade deficit anda decline in individuals’ savings rates inAmerica relative to other countries.
Whatever the reasons, forex is attractingattention as a strategic holding.“Currency risk certainly intrigues us,”says Jerry Miccolis, senior financial advisor at BrintonEaton Wealth Advisors in Morristown,N.J. “A currency play is something we’vediscussed and debated,” although thefirm continues to favor unhedged positionsin foreign stocks and bonds for owning currencies.At Main Management LLC in San Francisco,portfolios for high-net-worth clientsmay hold as much as 5 percent in a currencyETF that specializes in the so-calledcarry trade—holding currencies in countrieswith relatively high short-term interestrates and shorting the lower-yieldingones. Diversification is the selling point,says Kim Arthur, the firm’s CEO. He expectsthat PowerShares DB G10 CurrencyHarvest ETF (DBV) will earn equity-like returnsand post low correlations with thestock market over time.
Currencies were added to the strategicmix three years ago for individual clientsof Lehman Brothers, reports Aaron Gurwitz,managing director of the portfolioadvisory group at the firm’s private investmentmanagement division in NewYork. “Most prospective and current clientshave a larger proportion of their investmentportfolios denominated in U.S.dollars than we think advisable,” he says.“Generally, we recommend that U.S.-dollar-based clients have at least 25 percentof their investments in vehicles not denominatedin U.S. dollars.”
Gurwitz favors several strategies foraccessing forex, ranging from unhedgedforeign equities to structured notes thatare indexed to the performance of one ormore currencies. Lehman also uses a privatelymanaged fund run by Samson CapitalManagement in New York. Samson’scurrency program seeks to outperform theinverse of the U.S. Dollar index, a popularbenchmark of the greenback as measuredby the leading foreign currencies. The fundis notable because most of its investorsare high-net-worth individuals.
The dollar’s decline of late has aidedthe tactical allure of currency funds, butis there a case for a dedicated currencyallocation as a long-term proposition?Yes, thanks to the evolution of the globaleconomy, says Jonathan Lewis, a portfoliomanager at Samson who chairs the firm’sinvestment committee. For decades afterWorld War II, the United States was the undisputed“economic hegemon,” Lewis explains.Standing atop the world economysimplified the investment outlook for severalgenerations of Americans. “One of thebenefits was the wonderful experience ofnot having to worry about the rest of theworld. The thinking was that you could befully invested in U.S. dollar-denominatedassets and capture the lion’s share of theworld’s best opportunities.”
In 2008, fewer investment strategistssee America’s opportunities in the globaleconomy in such starkly positive terms. Tobe sure, the U.S. remains the planet’s largesteconomy and by several crucial measuresremains an attractive destinationfor capital investment. What’s changedhas less to do with the decline of America,real or perceived, and more with the rise ofcompetition—particularly in the developingworld.
Lewis emphasizes that America representsa large, but declining piece ofan expanding investment pie. “The U.S.economy, while important and dominant,doesn’t reflect the opportunity set of allthe best possible choices,” he says. Asglobalization expands its reach and influence,foreign assets should be reflectedin investment portfolios. “If more and more of yourbasket of goods is coming from other places, youshould, as a conservative investor, have some exposureto those places [for reasons that go] beyondwhether or not you have an equity market outlookin those places.”
The academic argument for always holding someforeign currency risk in investment portfoliosdates to at least 1989 and FischerBlack’s “Universal Hedging: OptimizingCurrency Risk and Reward in InternationalEquity Portfolios” in the Financial AnalystsJournal. Black offers a simple formula forestimating how much to hedge foreigncurrency exposure. The formula has threeinputs, each calculated from the averageacross individual countries for
* expected excess return on theworld market portfolio (R)
* volatility of the world marketportfolio (V)
* the average across all pairs ofcountries of exchange ratevolatility (E)
The data points are then analyzed as
R - V^2
-----------
R – (1/2*E^2)
The result produces what Black identifiesas the “optimal hedge ratio,” or “thefraction of your foreign investments youshould hedge.” The paper concludes thatall investors, regardless of country, shouldhedge only a portion of their foreign investments.Why not hedge away forex completely?Because “taking some currencyrisk” boosts a portfolio’s expected returns,he advises.
The challenge is deciding how muchcurrency exposure is optimal. The answerpartly relies on the risk and return objectivesof the investor. The markets are afactor, too. Returns and volatilities fluctuateover time, and so Black’s hedging ratiovaries, depending on the historical periodchosen for analysis. In his paper, Blackcites two examples drawn from slightlydifferent stretches of market data in the1980s. He writes that the two results forthe recommended portion of a portfolioto hedge dollar exposure were 30 percentand 73 percent. That leads Black to warn,“Straight historical averages vary toomuch to serve as useful inputs for the formula.Estimates of long-run average valuesare better.”
Estimating future input values is necessarilysubjective, but the larger messageis that no investment portfolio shouldbe 100 percent hedged against forex risk.The reason is due to the fact that the riseof one currency relative to another is alwayslarger in percentage terms than thepercentage depreciation in the other. Thatleads to the conclusion that investorsin any two currencies, for instance, canboost expected returns by holding bothcurrencies. The phenomenon—known asSiegel’s paradox—was first noted morethan 30 years ago by economist JeremySiegel (“Risk, Interest Rates, and ForwardExchange,” Quarterly Journal of Economics,May 1972).
While there’s an academic case for alwaysholding some degree of forex risk,most wealth managers prefer tapping currenciesthrough unhedged foreign stocksand bonds. One motivation is efficiency. A15 percent allocation to currencies proper,for instance, means pulling assets fromsomewhere else. “Whatever assets youuse to place a currency bet, you don’t haveto invest elsewhere,” says Brinton Eaton’sMiccolis. Alternatively, investing in unhedgedforeign stocks or bonds deliversa currency and securities stake, effectivelyproviding a two-for-one deal.
“We get our currency diversificationstraight through equity index funds thatwe use,” Rick Ferri, founder and CEO ofPortfolio Solutions LLC in Troy, Mich.,tells Wealth Manager. “Direct [currency]overlays are fine if you’re managing verylarge sums of money.” Short of superwealthy individuals or institutional portfolios,currency diversification by way ofunhedged stock and bond funds is thebetter choice, he asserts.
Echoing Miccolis’ point, Ferri notes thatpure currency allocations, and so-called alternativestrategies in general, may incuran opportunity cost in the long run. Fundingan allocation in currencies by takingit out of equities may look attractive on ashort-term basis. “Yes, you may lower theoverall risk of your portfolio,” he concedes,“but there’s a very good likelihood thatyou’ll also lower the return.”
Nonetheless, there’s a bull market inbringing exotic betas and alternative strategiesto the masses via publicly tradedfunds. But in his recently published TheETF Book (Wiley, 2007), Ferri counsels thatthere’s a risk that the expected diversificationbenefits may be offset by fees, inflationand a lower tax efficiency. Regardless,innovation in ETFs rolls on. “Hopefully,”Ferri writes, “the fees to invest in thoseproducts will be low enough so that theybenefit buy-and-hold portfolios as well asan active trading portfolio.”
The result produces what Black identifiesas the “optimal hedge ratio,” or “thefraction of your foreign investments youshould hedge.” The paper concludes thatall investors, regardless of country, shouldhedge only a portion of their foreign investments.Why not hedge away forex completely?Because “taking some currencyrisk” boosts a portfolio’s expected returns,he advises.
The challenge is deciding how muchcurrency exposure is optimal. The answerpartly relies on the risk and return objectivesof the investor. The markets are afactor, too. Returns and volatilities fluctuateover time, and so Black’s hedging ratiovaries, depending on the historical periodchosen for analysis. In his paper, Blackcites two examples drawn from slightlydifferent stretches of market data in the1980s. He writes that the two results forthe recommended portion of a portfolioto hedge dollar exposure were 30 percentand 73 percent. That leads Black to warn,“Straight historical averages vary toomuch to serve as useful inputs for the formula.Estimates of long-run average valuesare better.”
Estimating future input values is necessarilysubjective, but the larger messageis that no investment portfolio shouldbe 100 percent hedged against forex risk.The reason is due to the fact that the riseof one currency relative to another is alwayslarger in percentage terms than thepercentage depreciation in the other. Thatleads to the conclusion that investorsin any two currencies, for instance, canboost expected returns by holding bothcurrencies. The phenomenon—known asSiegel’s paradox—was first noted morethan 30 years ago by economist JeremySiegel (“Risk, Interest Rates, and ForwardExchange,” Quarterly Journal of Economics,May 1972).
While there’s an academic case for alwaysholding some degree of forex risk,most wealth managers prefer tapping currenciesthrough unhedged foreign stocksand bonds. One motivation is efficiency. A15 percent allocation to currencies proper,for instance, means pulling assets fromsomewhere else. “Whatever assets youuse to place a currency bet, you don’t haveto invest elsewhere,” says Brinton Eaton’sMiccolis. Alternatively, investing in unhedgedforeign stocks or bonds deliversa currency and securities stake, effectivelyproviding a two-for-one deal.
“We get our currency diversificationstraight through equity index funds thatwe use,” Rick Ferri, founder and CEO ofPortfolio Solutions LLC in Troy, Mich.,tells Wealth Manager. “Direct [currency]overlays are fine if you’re managing verylarge sums of money.” Short of superwealthy individuals or institutional portfolios,currency diversification by way ofunhedged stock and bond funds is thebetter choice, he asserts.
Echoing Miccolis’ point, Ferri notes thatpure currency allocations, and so-called alternativestrategies in general, may incuran opportunity cost in the long run. Fundingan allocation in currencies by takingit out of equities may look attractive on ashort-term basis. “Yes, you may lower theoverall risk of your portfolio,” he concedes,“but there’s a very good likelihood thatyou’ll also lower the return.”
Nonetheless, there’s a bull market inbringing exotic betas and alternative strategiesto the masses via publicly tradedfunds. But in his recently published TheETF Book (Wiley, 2007), Ferri counsels thatthere’s a risk that the expected diversificationbenefits may be offset by fees, inflationand a lower tax efficiency. Regardless,innovation in ETFs rolls on. “Hopefully,”Ferri writes, “the fees to invest in thoseproducts will be low enough so that theybenefit buy-and-hold portfolios as well asan active trading portfolio.”
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