Adding Currencies to Your Portfolio
Diversification is critical for long term portfolio health. We’ve all heard about the benefits of not putting all your eggs in one basket, but conventional wisdom needs to be updated every now and then.
The modern investor has a wealth of new tools to achieve real diversification. Small investors are encouraged to spread their portfolios across a range of stocks and bonds. Small caps, mid caps, large caps, value, growth, short and long-term Treasuries, and municipal bonds have been the staple of a diversified portfolio. Well, times have changed and so too should your notions of eggs and baskets.
With the emergence of exchange-traded funds (ETF’s) there has sprung forth tremendous new tools for diversifying individual portfolios. Stocks and bonds can now be supplemented by precious metals, natural gas, oil, agricultural commodities, real estate, sub sectors of the economy (retail, financials, energy, etc.), targeted global markets, and currencies.
A great way for American investors to hedge inflation and the decline of the dollar is to purchase currency ETF’s. These instruments enable investors to gain exposure to specific foreign currencies, which are often uncorrelated to US stocks and bonds.
Overall portfolio risk can be measured in the variance of returns, which is a function of the individual assets held. To decrease total system variance it is best to include assets that are negatively correlated to each other.
Someone holding predominantly US stocks in their portfolio should consider adding currencies that are negatively correlated. It turns out that Swiss Franc, Japanese Yen, and Swedish Krona move in opposite directions as US stocks, while Australian dollar, Mexican Peso, and Canadian dollar move in the same direction.
Holding Swiss Franc, Euro, Yen, or Krona would have yielded roughly between 12% and 17% in capital appreciation over the last year. Not only that, but each ETF has a dividend yield, representative of interest rates within each country.
An income investor should consider holding Mexican Peso, Australian Dollar, and British Pound, while avoiding Yen and Swiss Franc. There are many factors to take into consideration, but applying basic portfolio theory to your own holdings can have signficant long term results.
Currency ETF’s offer a great alternative to traditional methods of diversification and are great to offset further declines in our own currency. Consider that commodities price growth is largely attributable to US dollar depreciation and you can see how foreign currencies can insulate individuals from energy, food, and other commodity-driven inflation.
