With large government deficits and slow economic growth keeping the U.S. dollar weak, an increasing number of advisors are wondering if a stake in foreign currencies may help client portfolio performance.

At the very least, it should reduce a portfolio's volatility. Foreign currencies have a low correlation to U.S. stocks and bonds ranging from 0.42 to -0.13, according to Merk Investments in Palo Alto, Calif.

Mitchell Ratner, finance professor at Rider University in Lawrenceville, N.J., says it makes sense to have a stake in a basket of non-dollar-denominated currencies. The currency position, he says, should run at least 5% of an investor's portfolio. Also, 20% to 30% of a mutual fund portfolio should be in foreign stock funds and/or bond funds. "The diversification benefits are clear, and the recent weakness in the U.S. dollar has bolstered both foreign earnings of U.S. firms and the value of foreign investments, including cash," he says.

Ratner suggests that financial advisors' risk-averse clients can invest in foreign currency CDs or a basket of currencies at Everbank.com. Other investors might consider foreign currency mutual funds and exchange-traded funds. For maximum risk in relation to return, currency futures contracts may be an option for sophisticated investors.

"The bottom line is achieving optimal, if not sufficient, diversification benefits," he says.

Ratner's research supports his contention that foreign currencies are a suitable asset class. His study found that from 1975 through 2006, adding a basket of six foreign currencies to a portfolio of U.S. stocks and foreign stocks improved the portfolio's Sharpe ratio compared with an all-stock investment. A Sharpe ratio measures the return per unit of risk. The higher the Sharpe ratio, the better. Ratner's study, "The role of foreign currency investment in a global equity portfolio," was published in the July 2007 issue of the Journal of Financial Planning.

The currencies used in the study included the Australian dollar, the Canadian dollar, the British pound, the Swiss franc, the Japanese yen and the euro. Ratner used a portfolio optimization technique, based on both actual and simulated data to test the long-term portfolio implications of foreign currency investments.

The results indicate that investments in foreign currency improved the Sharpe ratio and worked as a defensive asset. In Ratner's study, the base scenario was 100% U.S. equities. In addition, four optimized portfolios were created.

For example, a 100% stake in U.S stocks registered a Sharpe ratio of 0.30 from 1975 through 2006. By contrast, a portfolio with 95% in U.S. stocks and 5% in foreign currencies had a higher Sharpe ratio of 0.47. Meanwhile, a portfolio with U.S. stocks, foreign stocks and foreign currency registered an even higher Sharpe ratio of 0.55.

Based on total return, there was negligible difference in annual rates of return among the groups. The study, however, suggests that financial advisors can't depend on foreign stocks and/or bond funds for currency diversification. Reason: Foreign stock markets have higher correlations with U.S stocks. As a result, there is less risk-reducing potential than pure holdings in foreign currencies.

Axel Merk, manager of the Merk Hard Currency and Absolute Return Fund, agrees. Reason: Foreign currency funds have much greater liquidity than international stock funds. They also have nearly zero or negative correlations to U.S. stocks and bonds.
"FX [currency asset class] is the least volatile market, when compared to equity and bond markets," he says. "There is a popular misperception that the currency asset class is more risky than the traditional asset class. Using volatility of returns as a measure of risk, the currency asset class has historically demonstrated lower volatility compared to equities and fixed income."

Merk says the U.S. dollar will remain weak for a long time due to a huge government deficit, a sick economy and pending inflation. As a result, he is investing in short-term foreign money market debt with maturities of 180 days or less in Merk's Hard Currency Fund. Meanwhile, the Merk Absolute Return Fund, which is designed to have zero correlation with the U.S dollar, takes long and short positions in the dollar and other major currencies, aiming to profit regardless of the direction of the U.S. dollar.

Unlike the United States, foreign central banks have provided liquidity to the banking sector, but not to specific areas of the economy, he says. Plus, most central banks already reduced their security purchases. This leads to less inflationary pressure compared with the United States.

The balance sheets of other nations are in better shape than those of the United States, Merk adds. For example, Norway is running budget surpluses and price stability. Australian and New Zealand central banks have taken a conservative approach in dealing with the credit crisis.

"The U.S. is printing more money than other countries," he says. "The dollar is weak and deteriorating. A flight to safety will benefit the U.S. dollar less than in the past. The U.S. dollar will be a loser for a very long term."

Although foreign currencies have a low correlation to U.S. assets, others believe you get plenty of diversification by investing in foreign stocks and bonds. Michael Kuziw, senior vice president with Lenox Advisors, New York, says his company gets currency exposure with short-term foreign government bond debt, foreign longer-term government and corporate bonds as well as foreign equities.

Lennox takes a top-down approach to asset allocation and leaves the currency, stock and bond pricing to fund portfolio managers. In 2009 through mid-November, Lennox had increased its non-dollar-denominated positions to 5% of client assets.
"It [non-dollar-denominated positions in stocks and bonds] helped the drawn-down measures of volatility," he says. "The draw-downs are lower and mitigate volatility. Our non-dollar assets are up 25% and dollar assets up 16% this year."

David Fingold, manager of the Global Discovery Fund, opposes allocating assets with pure foreign currency investments and certificates of deposit. "You get enough [currency diversification] putting money into foreign stocks and bonds," he says. "Anytime you get a structured product, like foreign currency CDs, ETFs or mutual funds, you get a static basket. There are fee overlays, pricing and transparency issues." Foreign currency exchange-traded funds also have tracking errors-the market price of the exchange-traded fund can differ from the market value of the basket of currencies managed by the fund, he adds.

Research also suggests that more active asset-allocation management with foreign currencies may be a better way to diversify than buying and holding currency for the long term. A study by Jack Dean Glen, lead portfolio officer with the International Finance Corp. in Washington, D.C., found that from 1974 through 1990, currency hedging using forward contracts significantly improved the performance of bond portfolios. Glen's study, "Currency Hedging for International Portfolios," was published in the December 1993 issue of the Journal of Finance.

More recently, research by Karen Benson, University of Queensland, Brisbane, Australia, found that during the mid-1997 Asian financial crisis, managing currency risk over the short term improved portfolio performance.

Meanwhile, a 2006 working paper by Harald Hau, finance professor with Center for Economic Studies, London, found that money can flow out of foreign currency assets as quickly as it can flow in. That's because cash flows into foreign equities are positively correlated with foreign currency appreciation.

On the investment company side, mutual fund portfolio managers are bearish on the dollar. Gregg Wolper, analyst at Morningstar Inc., says the vast majority of foreign stock funds are not hedging foreign currency positions. "Most international equity funds are completely unhedged," he says. "The managers typically explain that their shareholders prefer that arrangement, saying that they own the fund not only to diversify into foreign stocks, but into currencies as well."

As a result, mutual fund investors have a large stake in foreign currencies. And those funds could experience large losses if the dollar strengthens substantially due to rising interest rates or an international flight to safety.

Edward Yardeni of Yardeni Research, Great Neck, N.Y., is bearish on the dollar. Nevertheless, he says the dollar could strengthen if there is a financial crisis.

"A renewed financial crisis might be bullish for the dollar," he says. "After all, the dollar rallied from July 2008 through March 2009 when there was a great deal of financial turmoil. Risk aversion seems to benefit the dollar much more than other currencies."
Despite the unhedged positions of numerous foreign mutual funds, Wolper says many funds are not averse to changing directions. For example, in 2007 and early 2008 when the dollar was stronger, a number of funds hedged their currency exposure.

Although investors may benefit today from adding currency positions to their portfolios, either in the form of foreign mutual funds or foreign currency funds, others aren't so sure it is absolutely necessary.

William H. Browne, managing director with Tweedy, Browne Fund Group, says over the long term, hedging a portfolio of stocks doesn't matter. For example, the difference between the annualized returns of the MSCI EAFE Index in U.S. dollars and the MSCI EAFE Index, hedged to the U.S. dollar, was only 2 basis points over the past 16 years, ending in September 2009. The hedged index returned 5.19% annualized and the unhedged index returned 5.21%. Tweedy, Browne Global Value Fund hedges its foreign currency positions.

Nevertheless, in October, the investment company launched the Global Value Fund II, an unhedged foreign stock fund, due to investor demand. "In doing this, we are in no way suggesting that investing on an unhedged basis is preferable," Browne says.
"The empirical evidence and our experience in managing the Global Value Fund continue to suggest that over long measurement periods, exposure to foreign currency is not a meaningful addition to the total return." Over shorter periods, foreign currency fluctuations could create substantial differences in performance between these two funds, he adds.

"We would expect this unhedged fund to have similar returns to our existing Global Value Fund over the long term," Browne says.