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.