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.

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