January 14, 2019
So recently one of my colleagues was planning a rather extended business trip to London and decided to add another week of leisure travel to the continent and our discussion turned to his need for currencies for the trip. How much should he bring with in British pounds or euros to have convenient access for taxis or small purchases? I recommended bringing about $100 or so in each currency just to make sure he had the flexibility to catch a cab or buy a drink when he arrived, then he could use his credit card for most purchases to get the best exchange rate. The conversation brought to mind the need for currency diversification in your investment portfolio. It’s an interesting and timely question given the recent trend in tariffs and trade wars, but perhaps a bit of history might help at the start of the conversation.
Back in the old days of the classical gold standard nations defined their currencies in terms of gold, the advantage of which was that gold was universal. An ounce of gold was the same in the United States as it was in China or France or anywhere else on the globe. So if the United States defined an ounce of gold being worth $20.67 and France defined an ounce of gold being worth 107.125 francs, then just do the easy math and $1 would equal 5.18 francs (107.125 ÷ 20.67) and the exchange rate would remain the same as long as the nations in question maintained their pegs to gold. Imagine the boon to international trade and the reduction in volatility if companies could trade and not have to worry about fluctuating exchange rates! This system persisted even in under the Bretton Woods system after World War II, until Nixon finally closed the gold window in 1971. Since then we have endured floating exchange rates impacting trade, balance of payments and ultimately how much cash my friend needed to bring on a trip to Europe.
From a portfolio perspective, each of us is heavily weighted toward our home currencies which begs the question, if portfolio diversification benefits returns on our investments, shouldn’t currency diversification also provide benefits to our total returns? For those of us in the United States, the lion’s share of our currency exposure is in dollars, our incomes from work are in dollars, our expenses are in dollars and our investments are in dollars. The same holds true for investor in Europe and their exposure to euros, and many other nations. For those of us in the United States, we might not think much about currency exposures given the fact that the dollar is the world’s reserve currency, but history is littered with the remains of former reserve currencies. Most recently, the British pound was the world’s reserve currency, and then it was displaced by the U.S. dollar with the Bretton Woods agreement following World War II. The pound’s value went from a pre-World War I peak of $4.86 to its recent value of around $1.30 – imagine what how that would impact your portfolio performance!
So how can individual investors approach the currency markets? Perhaps the first question investors should ask is whether they are approaching currency investing from a speculative or hedging perspective. If you are looking to hedge some of your home currency exposure (and here hedging is a term used loosely as there is a certain amount of speculation involved in determining how to hedge), clearly it’s not very practical to go to a bank or foreign currency exchange kiosk and exchange greenbacks for foreign banknotes. Certainly it’s an option, but not particularly convenient or liquid. Instead you might look at one of the many liquid ETFs focused on foreign currency as a way to hedge. There are ETFs that provide returns based on bearish positions on the U.S. Dollar Index, which would provide positive returns should the dollar begin to fall relative to a basket of currencies in the index. Investors might consider long foreign currency ETFs focused on what may be the most likely currencies to benefit from dollar weakness, such as the Euro. You might also consider a long ETF based on the currencies most likely to replace the dollar as the next reserve currency, which most investors believe will be the Chinese yuan. If your goal is to speculate, you have many options based on your market expectations. ETFs for emerging market currencies, individual developed market currencies, and long or short currency exposure are all broadly available depending on your view of the market.
The bottom line when it comes to currency investing is to bring the denominator to the forefront. This is something investors seldom consider, as we like to remain insulated in our home currency bubble. But when you consider that strong stock market returns measured in dollars might quickly evaporate in a weak dollar environment, you’ll begin to appreciate the importance of keeping an eye on the denominator used to measure your returns.
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