— Posted Thursday, 8 September 2011 | | Disqus

Introduction

In a previous White Paper titled U.S. Investors Overexposed to U.S. Dollar Risk?, we discussed the aggregate level of U.S. dollar risk inherent in U.S. investors’ assets. This research report takes the analysis further. The aim of this paper is to analyze in greater detail the potential actions investors may take, not only to address concerns surrounding further deterioration of the U.S. dollar, but to diversify currency holdings in general.

As we discussed in the White Paper referenced above, nearly 90% of aggregate financial holdings may leave U.S. investors susceptible to U.S. dollar risk. As such, diversification away from the U.S. dollar may be an important consideration for many investors. In this context, this analysis introduces and elaborates on the different options available to investors, and discusses potential advantages and disadvantages of each alternative.

We start our analysis with perhaps the most commonly utilized vehicles employed to help diversify outside the U.S. dollar: listed currency vehicles – mutual funds and exchange-traded products. Secondly, we assess the poten tial currency diversification benefits brought about by investments in international debt securities and international equities. We also analyze equity investments in listed domestic corporations, particularly U.S. exporters, where we show that the underlying exposure investors gain to foreign currencies may not be quite as high as expected. Investments in precious metals, commodities and natural resources are also discussed. Finally, we assess currency overlays as an effective tool to diversify away from the U.S. dollar. We show that while derivatives may not be suitable for all investors, they may fulfill important investment requirements if managed prudently. Moreover, investors may wish to consider incorporating a currency overlay investment approach utilizing derivative investments to manage the inherent U.S. dollar risk of certain asset classes or specific securities, while maintaining a fully invested position in those securities.

In the present market environment, investors appear increasingly concerned about the future of the U.S. dollar. The recent weakness in the currency underscores these concerns. We believe several key structural factors are likely to contribute to ongoing weakness, including growing disparity in monetary and fiscal policies around the world, which are likely to continue to put downward pressure on the U.S. dollar over the medium to long term. Furthermore, our research shows that many U.S. investors are typically overexposed to the dollar; hence this topic area may be of the upmost importance for many U.S. based investors. We believe ongoing concerns surrounding U.S. dollar weakness help explain why there has been a plethora of currency investment options launched recently, aimed specifically at diversifying investor’s holdings away from the U.S. dollar.

The chart below depicts U.S. dollar weakness over the past 10 years through 07/29/11, as measured by the U.S. Dollar Index:

Listed Currency Vehicles

From an investment perspective, investing in listed currency vehicles, such as mutual funds, exchange traded funds and exchange traded notes may provide the most readily available currency investment options. Generally speaking, listed currency vehicles can be classified as directional or non-directional. Directional investment approaches generally take a specified position in a single currency or managed basket of currencies, typically either long or short vs. the U.S. dollar. In contrast, non-directional investments have no pre-determined view on any one currency; non-directional currency investments may take long or short positions in a variety of currencies. Exchange traded products commonly exhibit directional investment objectives, while mutual funds tend to be both directional and non-directional in nature. This investment approach is an important consideration when assessing investments in listed currency vehicles. For a more detailed discussion on the various attributes of currency mutual funds, exchange traded funds (ETFs) and exchange traded notes (ETNs), please see our white paper entitled Currency Investing – Mutual Funds, ETFs & ETNs.

Listed currency vehicles may provide investors with valuable diversification benefits, and indirect access to the return series generated by a single currency or basket of currencies. In many ways, employing listed currency vehicles may be the cleanest or purest form of accessing the currency asset class. Listed currency vehicles typically don’t have the added risks associated with international equity or bond funds (discussed in more detail below), namely stock-specific and market risks, credit and interest rate risks, so from that perspective they may provide investors with predominantly currency price exposures. Currency price movements have historically exhibited lower levels of volatility relative to traditional asset classes like equities, so adding listed currency vehicles may enhance a portfolio’s risk-return profile. Indeed, over the previous 10 years, indices tracking a directional approach (inverse of the U.S. dollar index) and non-directional approach (Deutsche Bank Currency Returns Index) both outperformed the S&P 500 Index on a risk-return basis:

International Equities and Fixed Income Securities

Investing in international stocks and bonds can provide investors with diversification outside of the U.S. dollar. We estimate international equity and fixed income holdings represent approximately 7.9% of aggregate U.S. private sector financial assets. 2 However, the degree of international currency diversification derived from this allocation may not be quite as high as many assume. There are a number of considerations that should be taken into account. First, stated or intended currency hedging policies will have a large bearing on the overall level of international currency exposure investors may ultimately access. Many investors lack the expertise, knowledge or experience trading and researching international markets, and thus may invest in international equities or fixed income through a listed mutual fund or other asset manager. Important here is to understand the currency hedging policies of such an asset manager; international currency diversification may be essentially nonexistent should the asset manager decide to hedge the international exposures 100% to the U.S. dollar. When an asset manager hedges a fund’s international currency exposures 100% to the U.S. dollar, investors effectively only access the equity and/or fixed income exposures of the underlying holdings. 100% hedged, or fully hedged, international stock and bond funds are common. On the other hand, while many funds may not specifically state a fully hedged objective, many asset managers employ a hedging policy nonetheless, albeit less stringently, allowing managers to set currency hedges at their discretion. This may create a lack of transparency and opaqueness regarding the degree of international currencies to which investors may inherently be exposed. Moreover, if the currency asset class is not a primary focus of such an international fixed income or equity asset manager, sporadic currency allocation changes may detract from overall fund performance. Understanding the hedging policies of any asset manager is key in determining the level of currency exposure an investor may ultimately gain in such a fund.

Even if a fund is unhedged, exposed primarily to the currencies that the underlying securities are denominated, security selection itself has a large bearing on the degree of international currency exposure an investor ultimately accesses. Let us examine an unhedged international stock fund as an example. Such a fund might invest in a broad basket of international equity markets, from Asia to Europe, to Latin America or Africa, or it may focus on a spe cific region of the world. Regardless of the geographic focus of the fund, the underlying equity investments will have a large bearing on the overall level of international currency exposure. For instance, assume the fund holds investments in the stocks of international exporters: many international exporters sell goods to the U.S. consumer and have costs tied to the U.S. dollar (many raw materials are priced in U.S. dollars). Therefore, much of their revenues and cost base may be denominated in U.S. dollars, so international currency diversification benefits from an equity investment in such a corporation may be somewhat muted. Furthermore, corporate currency hedging policies will have a large bearing on the degree of international currency exposure an investment in each individual international equity represents (we’ll discuss corporate hedging policies in greater detail below, as it relates to U.S. corporations); suffice to say, if an international corporation is more active in hedging currency exposure to the local currency, investors may in turn gain greater level of exposure to that currency, and visa versa.

Another consideration is the degree to which international equity and bond investments are susceptible to com pany-specific risks, general market risk, credit risk, interest rate and duration risks. Importantly, these risks may generate the vast majority of realized returns and volatility in price. International equities in general have historically exhibited much higher levels of volatility relative to currencies, as evidenced in Chart 3. International fixed income asset managers will often play the credit curve and yield curve, generating the vast majority of returns in this fashion, but in turn may generate additional risks for investors. In an environment with rising interest rates globally, investors should consider the average maturity profile and duration of international fixed income security investments. Many of the listed currency funds described above may help protect against these risks, predominantly providing investors with exposure to currencies, and potentially mitigating against risks specific to international equities or fixed income.

U.S. Equities

Currency exposure may be derived from owning U.S. corporate equities, particularly U.S. exporters and those corporations with large international operations. However, the degree of international currency exposure may not be as high as investors may think. By investing in a U.S. corporation that has significant international operating earnings, an investor is essentially creating a de-facto exposure to the currencies where those international operations are located; should the U.S. dollar fall relative to those currencies, the international business earnings will be enhanced when translated into U.S. dollars, which will in turn be reflected in higher earnings growth, and therefore drive the price of the stock up. In theory, this stock price appreciation should reflect the degree to which the corporation benefits from an appreciation of foreign currencies, holding all else constant. However, this de-facto currency exposure may be limited depending upon the extent to which the business employs currency hedging to manage it’s foreign currency exposures.

Corporate hedging policies are hard to determine with a high degree of accuracy for any business; accounting departments are loathe to disclose internal policies and financial statements often tend to shed little light on the matter. Notwithstanding, industry feedback and proprietary research determined that U.S. corporations are very active in hedging foreign currency exposures, specifically with regards to operating earnings. Using the analysis and discussion from our White Paper U.S. Investors Overexposed to U.S. Dollar Risk. we find that U.S. corporations actively employ economic hedging policies on international operations; approximately 80% of international income statement exposures are hedged back to U.S. dollars by listed U.S. corporations; the larger the business, the more active corporate hedging tends to be. As a result, we believe that equity investments in U.S. businesses generate a small portion of international currency exposure, even for those firms with a significant percentage of earnings derived internationally. Indeed, we estimate that only 8.9% of an investment in the aggregate S&P 500 index companies would provide international currency exposure, despite approximately 46.0% of S&P 500 corporate earnings being derived from abroad.

Precious Metals, Commodities, Natural Resources

Investments in precious metals, commodities and natural resources may present another way of potentially pro tecting against a decline in the U.S. dollar. These assets tend to appreciate in value in inflationary environments, and may therefore help protect against deterioration in the purchasing power of the U.S. dollar. As the dollar continues to weaken against other major currencies, holding all else constant, imports naturally become more expensive; the U.S. imports a great deal of commodities and natural resources, either directly (oil) or indirectly, through the importation of goods where commodities and natural resources make up a large proportion of the overall cost structure. Indeed, many imports sourced from Asia have been rising in price, as those manufacturers increasingly pass on the increased cost of doing business brought about by rising commodity and natural resource prices. Hence, investments in these very assets may help protect against these inflationary dynamics and further weakness in the U.S. dollar.

Our research finds that investors typically hold only a small portion of their assets in precious metals, commodi ties and natural resources. Exchange traded vehicles tracking the price of these assets comprise approximately 0.7% of total U.S. stock market valuation;3 assuming the U.S. private sector invests in stocks proportionately, this figure represents just 0.2% of aggregate private sector assets. Physical holdings of these assets are much more difficult to track. For instance, a portion of gold bar and coin holdings is likely classified as unidentified within Federal Reserve Statistics Department Release Z.1. Moreover, it appears there is a wide distribution in allocation to these assets from one investor to another, likely dependant on personal investment situation and outlook; a survey conducted by Merk Investments found that individual investor allocations to commodities, precious metals and natural resources exhibited a wide range, from 0% to over 50%.

Investing in exchange traded products may be the most convenient way for investors to access these asset classes. The present environment, with ongoing volatility in equity markets worldwide, unconvincing fiscal reforms in the U.S. and abroad, and the Federal Reserve’s continued easy monetary policy stance, appears to have underpinned demand for precious metal exchange traded products in particular, especially gold. This dynamic is best highlighted by the largest market capitalized exchange traded product in the space, SPDR Gold Trust (GLD), which has experienced significant appreciation in both price and market cap. Indeed, the market cap of GLD recently briefly surpassed that of SPDR S&P 500 Trust (SPY), the largest exchange traded product since 1993.

From a currency perspective, many consider gold the ultimate hard currency. Relative to fiat currencies, the supply of gold cannot be readily influenced. Central banks can print money, through such programs known as quantitative easing or monetizing government debt. When the supply of any currency increases (or the supply of any asset, for that matter), with no offsetting demand, that currency is likely to experience weakness, as manifested in a decline in purchasing power, otherwise known as inflation. Because gold cannot be easily inflated in the same way, it may hold its intrinsic value, which many consider to be an attractive attribute in the present environment.

While precious metals, commodities and natural resources may help provide protection against ongoing deterioration in the value of the U.S. dollar, one drawback may be the enhanced levels of volatility. Investors should be aware that these asset classes have historically exhibited very large swings in price, as evidenced by volatility of returns. Adding precious metals, commodities and natural resources may enhance a portfolio’s risk/return profile, and maintaining well diversified positions may protect investors from wild swings in price, and protect against downside movements.

Currency Overlay

Employing a currency overlay, by utilizing derivatives, may help investors manage the U.S. dollar and currency risks inherent in an asset class or security. While the very utterance of the word derivative may invoke reserva tions and skepticism, derivatives may provide beneficial diversification benefits if used judiciously. It is true that derivatives have recently garnered a bad name, predominantly due to repercussions of irresponsible utilization of credit default swaps (CDS), which ultimately contributed to the financial crisis and downturn in world economic growth. However, understanding and employing currency derivatives prudently may provide investors with desired levels of currency exposure, and in some cases, maintain fully invested positions in desired asset classes.

Employing derivatives can completely change the profile of any investment portfolio, especially if used with a large degree of leverage. That is not the point of this discussion. Rather, derivatives can be used primarily as a means of modifying underlying currency exposures. Specifically, employing derivatives may help an investor manage the U.S. dollar risk inherent in a particular asset class, without the need to adjust the proportional portfolio exposure of that same asset class. In this context, investors may wish to consider a fully collateralized currency overlay. For instance, investors wishing to gain exposure to U.S. equities, but concerned about the U.S. dollar risk intrinsic to them, as alluded to above, could employ a currency overlay strategy to help address the implicit U.S. dollar risk of those securities.

Commonly used in the currency market are forward currency contracts and futures contracts. Futures are standardized and traded on a public exchange. Standardization of futures contracts refers to the expiration date and the contracted amount. On the other hand, forward currency contracts can be tailored to meet the specific requirements of the purchaser or seller and are traded over the counter. Forward currency contracts are not restricted by size or value date, and therefore oftentimes can meet the needs of investors more precisely.

While investors have to pay for the futures contract and may need to post certain margin requirements, there is often no initial outlay needed for a forward currency contract, as collateral is often not required. As a result, an investor using forward currency contracts may be free to deploy funds into various investments until the value date of the contract. Using the U.S. equity example introduced above, an investor could utilize forward currency contracts to achieve the desired level of currency exposure, taking into account the large U.S. dollar exposure inherent in U.S. equities. The size of the currency overlay could be constructed to proportionally match the desired level of currency risk the investor wishes to manage. Concurrently, if there is no initial outlay, this same investor may stay fully invested in U.S. equities. Clearly, derivatives can present an efficient way to access the potential diversification benefits of the currency asset class and diversify away from the U.S. dollar.

Such an investment strategy may enhance the risk-return profile of an investment in U.S. equities. The charts below outline the risk-return profiles and Sharpe ratios of the S&P 500 Index compared to that of a strategy aimed at managing the currency risk of the S&P 500 Index (an investment in the S&P 500 Index combined with a 100% non-directional currency overlay), over various timeframes. Such a currency overlay is fully collateralized by the S&P 500 Index. (The DBCR Index is used as a proxy for the non-directional currency overlay.)

Employing a currency overlay in such a fashion increases both the risk and return profile over each timeframe depicted above. Notably, increases in returns are proportionally greater than increases in the standard deviation of returns, resulting in enhanced risk-adjusted returns, as measured by higher Sharpe ratios.

A drawback of forward currency contracts is that smaller individual investors simply don’t have access to these instruments. Individual investors often have the ability to trade in the futures market, but may lack the experience or expertise necessary to prudently utilize futures. Moreover, futures may not be as efficient as forwards in managing currency exposures. As a result, professionally managed funds that employ currency overlays to manage the currency risk of certain asset classes may be the most effective means to maintain exposure to an asset class while managing its inherent U.S. dollar and currency risk.

Conclusion

We have discussed the various approaches investors may consider to diversify away from the U.S. dollar and manage currency risk. When considering the options available to them, it is important for investors to consider and fully understand the intricacies as well as potential benefits and risks of each alternative. Investments in listed currency vehicles may be the most straightforward option available of those discussed. Notably, many commonly used approaches may not generate as large a degree of international currency exposure as one might think. Particularly, investments in international stocks and bonds as well as domestic equities need to be scrutinized to assess the overall international currency exposure to which an investor may ultimately gain exposure. Investments in precious metals, commodities and natural resources may provide investors with protection against ongoing deterioration in the purchasing power of the dollar, but may also expose investors to higher levels of volatility. We introduced the use of currency overlays in accessing currency exposure, where we have shown that employing derivatives may be effective and efficient in this respect. Specifically, derivatives may allow investors to manage the currency exposure of an asset class or security, while maintaining a fully invested position in that same asset class or security. Our findings show that a fully collateralized non-directional currency overlay may enhance investor’s risk-adjusted returns over various timeframes.

Merk Investments LLC | White Paper | September 2011

About the Author

Kieran Osborne, CFA is the Director of Research of Merk Investments. He is an expert on macro trends and currencies and has a comprehensive quantitative background. He oversees Merk in-house research and frequently publishes research reports focused on global economic trends.

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