Currency exposure can add diversification
and gains to portfolios-if you're careful.

    According to Morningstar, over the past three years ending May 26, the average global bond fund outgained the average domestically focused intermediate term bond fund by 225 basis points annually. Over the past five years, global funds returned an average of nearly 300 basis points more. The main driver of this outperformance: appreciating foreign currencies.
    According to Joseph DiCenso, global fixed-income strategist at Lehman Brothers, bond markets across most developed markets have seen negative returns so far this year through May. "But when you factor in the falling dollar, which boosts the underlying value of these investments for U.S. investors," DiCenso explains, "dollar-based returns are solid, led by Sterling bonds, up 7.03%, and euro-based bonds, which rose 6.25%."
    This is the power of foreign exchange. It's an integral part of all international investments, whether you're purchasing stocks in London or booking a hotel room in Venice. This is how it works.
    Let's say you purchased a euro-denominated security for $25,000 when the exchange rate was $1.20 per euro. That means you purchased 20,833 worth of assets. Assume the underlying value of the security doesn't change, but the euro appreciates against the dollar to $1.30. Because each euro is now worth more, when you sell the security and translate the proceeds back into dollars, the 20,833 is then worth $27,083-a gain of 8.33%.
    Even though currencies are in constant flux, there are several dozen currency pairs (e.g., dollar-yen or euro-sterling) that trade 24 hours a day with substantial liquidity, enabling investors to establish a long or short position in one currency relative to another.
    Any such exposure, however, requires regular monitoring to mitigate risks as well as to identify opportunities. This was never more true than after the euro's introduction in 1999 at $1.16; the new currency proceeded to collapse by nearly 30% over the next two years, hitting a low of $0.83 in November 2000. That meant that the value of the aforementioned $25,000 investment declined to $17,888, all else being equal.
    But this also meant that Eurozone-based securities were looking extremely attractive for dollar-based investors at that time. The cheaper currency made these companies' products more competitive in the United States by reducing their dollar-based prices, which boosted sales. Likewise, it made shares in these securities cheaper for U.S. investors. Four years later, the euro had appreciated by nearly 64%, peaking at $1.36 by the end of 2004, all of which translated to the bottom line for U.S. investors.
    "Currency has traditionally been viewed as a portfolio risk," says Iain Lindsay, of Goldman Sachs Asset Management's Global Fixed-Income and Currency division in London. "However, because foreign exchange markets are highly liquid and inefficient, skilled management can generate excess returns, supporting the case for regarding currencies as an asset class."
    Because long-term active currency returns are driven by a range of economic factors that differ from those driving equity and bond returns, says Lindsay, they tend to exhibit a low correlation with traditional investments. And he believes this makes foreign exchange an "essential component of portfolio diversification."

Not A No-Brainer
    Advisors should understand from the start that exchange rate movements are notoriously difficult to forecast over the near term. Professional foreign exchange investors are doing well if they get half their bets right. Unexpected economic data, misspeak by central bankers, internal political dissension, unrealistic market expectations, natural disasters-any such actions can trigger sharp, unexpected moves in exchange rates.
    Over the longer term, technical and fundamental analyses have proven useful tools for presaging shifts in foreign exchange. As with stocks, technical analysis is the study of exchange rate movement and trading volume trends. Investors who use this approach-known as systematic traders-rely on computer models to discern a breakout from range-bound trading. When this occurs, traders establish positions. At the same time, they set quick stop-loss orders to minimize risk. If the trend plays out, traders will continuously raise stop-loss orders to sell out of a position once the trend starts breaking down.
    Fundamental investors, known as discretionary traders, look at macroeconomic factors that historically correlate with a country's currency performance. Remember, performance is not absolute-it's relative to another currency. It's possible for the dollar to fall against the euro while rising against the South African rand. So this analysis looks at the relative, or differential, value of these metrics, which include economic growth and interest rates, pace of inflation and budget and current account balances.
    Eric Lonergan, currency analyst for London-based bank Cazenove, utilizes elements from both camps to call market moves. Without clear triggers or trends, it's more challenging to forecast movements, he observes. "However, when we saw the dollar collapse at the end of 2004, from $1.21 in mid-September to $1.36 by 31 December," recalls Lonergan, "it was evident that the dollar had been caught in panic trading, given the generally sound state of the U.S. economy." He called for the dollar to rebound. By the second week in January 2005, the euro had retreated to $1.30. And by mid-December 2005, the dollar had rallied 14% to $1.17.
    Since the end of last year, the dollar has been trading in a narrow band against many currencies. "The lack of a meaningful trend makes it extremely difficult for currency traders to profit," explains Jeremy O'Friel, director of Dublin-based Appleton Capital Management, which manages $200 million in currency funds." For example, save for two months around the end of 2004 and the last six weeks in 2005, euro-dollar has been range-bound between $1.20 and $1.30 for over two-and-a-half years. As a result, his firm's benchmark 25 Percent Risk currency program is down nearly 5% for the past 12 months through May.
    This highlights the point that currency investing is not a short-term play. "Investors get attracted by strong performance, but then get hurt by quickly selling into down markets," O'Friel observes. His 25 Percent Risk program has generated annualized returns of 9.11% over the five years through 2005; the S&P 500 total returns were only 0.54%.

Gaining Currency Exposure
    Financial advisors can introduce foreign exchange exposure into client portfolios through passive and active means. The former is achieved by purchasing foreign securities. Buying shares of Nokia, for instance, gets you euro exposure, and UBS gets you into the Swiss francs. Country-specific exchange-traded funds, such as those offered by iShares, do the same thing. And all these liquid, dollar-denominated securities trade on U.S. stock exchanges.
    International and global mutual funds can also provide foreign exchange exposure. But it's far more opaque because country [i.e., currency] weighting will constantly vary, as well as the degree in which foreign exposure may be hedged out of performance. Active currency exposure, investments designed to profit exclusively from changes in foreign exchange, can be achieved through currency contracts (options, futures and forwards), specialized mutual funds, Commodity Trading Advisors (CTA) and bank accounts.
    Recently, ProFunds and Rydex have each introduced several currency funds, some designed to profit when the dollar is rising, others programmed to benefit from a weakening dollar. Rydex is in the process of bringing to market a half dozen ETFs, each of which is long an individual foreign currency.
    Started in 1989, the Franklin Templeton Hard Currency fund, with $291 million in assets, is one of the oldest such funds around. It's designed to excel when the dollar weakens. And over the past five years, it's produced annualized returns of 9.71% through mid-June.
    St. Louis-based Everbank World Markets enables investors to efficiently set up no-interest savings accounts in 15 different major and emerging market currencies. And it offers interest-yielding CDs in several liquid currencies, whose maturities range up to one year. Accounts are FDIC-insured, but losses due to foreign exchange are not. Like currency mutual funds, these are one-way bets against the dollar.
    For more diversified currency exposure that can profit regardless of the direction the dollar is heading, advisors should consider CTAs. Similar to hedge funds, they provide much greater transparency and liquidity and some have lower minimum investments, especially when sold through brokerages. According to the data-tracking service, The Barclay Group, the 38 CTAs that focus exclusively on currencies with five-year histories have generated annualized returns of 8.22% between May 2001 and April 2006. During the same period, the S&P 500 was up 2.69%. More intriguing, these CTAs have been able to deliver these returns with less than half the standard deviation of the S&P 500.
    Arun Muralidhar, managing director of research at FX Concepts, a New York-based currency advisory with $12 billion under management, believes high-net-worth individuals should have a third of their portfolio passively exposed to foreign exchange and another 5% in active currency products. His firm's Global Currency program has generated annualized total returns of 12.82% over the past five years through the end of April, with less monthly volatility than the S&P 500: 10.57% versus 13.47%.
    Anton Pil, global head of fixed income at JP Morgan Asset and Wealth Management, recommends slightly less currency exposure: 20% passive allocation. This is up from 15% in 2005 because of his positive outlook toward foreign markets and their currencies. And he recommends 2% active currency management.
    "In this highly globalized investment environment, the issue is no longer whether one can avoid foreign exchange exposure," says Eric Busay of CalPERS, who manages $17.5 billion in currency and international fixed-income investments, "but how to control risk and enhance total returns." 

Eric Uhlfelder has covered foreign markets and currencies for 15 years for major publications, and he authored Investing in the New Europe for Bloomberg Press in 2001.