long term currency positions as a portfolio diversifier?

3 Answers

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   Common Sense on Sep 03, 2011

   ETF’s, as you mention is the smartest way to do this. I strongly agree that diversification is important. Actually asset allocation is the most important. Using either philosophy, I don’t believe that currency investing is the way to go for 98% of us. This is much more risky than sector funds…. which I strongly discourage…. unless you’ll keep on top of the sector & have a "feel".

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   JoeyV on Sep 03, 2011

   It depends on how you measure performance of your portfolio. The usual way that we think about diversification is that diversification reduces risk, usually variability of the portfolio. You would usually measure variability of the portfolio in the native currency of the investor. Thus, a portfolio diversifier would reduce the variance in USD of a portfolio for a US investor. In that context, adding foreign currency exposure (with 0 expected return) just adds variance to the portfolio because you are adding the variability of the foreign currency to your portfolio variance since you are denominated in USD.

   The situation changes if you change the portfolio numeraire to gold, for instance. If you denominate your portfolio in gold (forget about gold being denominated in USD) then having multiple currencies in your portfolio is real diversification because fluctuations in currencies will cancel each other out in the usual square root kinda way.

   So that brings you to the choice of what is the goal of your portfolio – to appreciate in terms of gold or to appreciate in terms of dollars? Most people have future expenses that are denominated in dollars so you want low volatility in dollars so diversifying in currencies is not smart. If you want low volatility in terms of gold bars for some reason, then you should diversify the currency held in your portfolio.

   Edit: Common Sense doesn’t understand this situation very well. And ETF’s are surely not the best way to add FX exposure to your portfolio – that would be futures contracts and (better still) forward contracts and (maybe even better still) FX swaps each of which is a vastly bigger market with way smaller fees than ETF’s

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   John W on Sep 03, 2011

   One of the primary tenets of modern portfolio theory is asset allocation. The simplified model is that of two asset categories that are negatively correlated or ideally uncorrelated. Liquidity is the other premise as it is necessary to rebalance to the asset allocation targets as often as possible subject to the costs of trading. Yes currency can serve as the not at risk category, yes currency is liquid and yes you can diversify against the local economy and politics by diversified holdings in foreign currencies but if you consider the credit default risk of bonds to be negligible or manageable with the appropriate insurance and you can augment the liquidity of bond holdings with margin then you are better off with a basket of bonds than with a basket of currencies. At least bonds have a nominal contractually obligated rate of return.

   I would see the use of a basket of foreign currencies as the counterweight to riskier investments as being a naive approach similar to using gold and silver as the primary low risk counterweight. Certainly no more than perhaps 18% of your portfolio in such a counterweight without contractually obligated returns can be considered reasonable with either commodities or foreign currencies.

   The 18% is an extrapolation from the Markowitz two asset category bullet where the lowest risk is from having 25% at risk and 75% not at risk therefore of the 75% of the not at risk category, you are allowing 25% to be in investments without contractual obligated returns but for various reasons are believed to still be considered not at risk. 18% is 25% of 75%. You’ll also hear people say not to exceed 6% in something, that too is extrapolated from the Markowitz two asset category bullet as it’s 25% of 25% and therefore is the limit of what to invest in truly risky investments. Finance is full of these rules of thumbs with only casual derivations often long forgotten.