Wealth Manager

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 below 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.”
One 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.

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

* expected excess return on the
world market portfolio (R)

R - V^2
-----------
R – (1/2*E^2)

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 and 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.”