"I think it's important to diversify with foreign currencies," says Feiger, who manages more than $1 billion in assets. "But there is the issue of timing."
Concerned about Uncle Sam's debt and the falling dollar, Greg Womack, an Edmond, Okla.-based financial advisor, says he has been successful in improving client risk-return portfolio profiles by holding some foreign currency mutual funds. Among those: Franklin Templeton's Global Bond Fund and its Hard Currency Fund. Both mutual funds have registered positive returns over the last three-year and five-year periods.
If advisors take currency positions, Feiger recommends using a number of technical and momentum indicators to invest in foreign currency exchange-traded funds, CDs or high-quality bonds. Those indicators identify rates of change in such factors as foreign exchange values, economic variables, commodity prices, interest rates and inflation. Political and economic policy changes also are important factors to consider.
Evaluating purchasing power parity is an important decision-making tool, he says. The buying power of different currencies is equalized based on goods bought and sold in the marketplace. The difference in the rate of change in currency prices in the United States and overseas is essentially due to inflation rates. So the difference in inflation rates between countries is equal to the percentage rise or fall in the exchange rate, he says. As a result, if one currency can buy more goods and services than another currency, it is more valuable, demand for the currency increases and that currency appreciates in value in relation to another currency.
"It [purchasing power parity] works quite well over the long term along with [currency] momentum," he says. "But not for day trading."
The notion that currency should be an important component in a diversified portfolio is supported by research, published by Mitchell Ratner, associate professor of finance at Rider University in Lawrenceville, N.J.
His study, published in the July 2007 issue of the Journal of Financial Planning, found that from 1975 through 2006, adding a basket of six foreign currencies to a portfolio of U.S. and foreign stocks improved the portfolio's Sharpe ratio compared with an all-stock portfolio. The Sharpe ratio measures the return per unit of risk. The higher the Sharpe ratio, the better.
Ratner suggests that financial advisors keep 5% of a client's portfolio in currencies and 20% to 30% in foreign stock and bond funds. For risk-averse clients, he suggests investing in foreign currency CDs or a basket of foreign currencies.
But buying and holding foreign currencies can be risky and volatile, according to a 2011 study published in the Journal of Portfolio Management by Michael Melvin, finance professor at Arizona State University. His research shows there are no benchmarks for evaluating a currency manager's performance. So how will a financial advisor who doesn't specialize in currency investing perform?
Few money managers have enough skill to time the foreign exchange markets. Those who are successful are the ones that minimize losses, he adds.
A less risky and popular alternative is investing in foreign corporate bonds. Diversification among foreign government bonds does not significantly affect the risk-adjusted rate of return on a diversified bond portfolio, according to a 2008 working paper by Mats Hansson, finance professor at the Swedish School of Economics in Helsinki, Finland. However, currency-hedged corporate bonds offer diversification benefits. Adding emerging market debt significantly improves the return per unit of risk.