Using Currency Mutual Funds to Build a Better Portfolio

Currency investing is one of the most frequently discussed alternative strategies, yet it remains one of the least understood. Investors often have several misconceptions about currency strategies—for example, that they are highly leveraged and volatile, and that they take large opportunistic bets on macroeconomic events. As a result, most investors view currency funds as a small tactical play at best.

However, currency mutual funds rarely possess these characteristics in reality. Furthermore, they can be an excellent hedging tool against the U.S. dollar risk and a great source of alpha. The 20 currency mutual funds available today can be categorized into two broad groups: directional and nondirectional. It's important for investors to understand the differences between the two before trying to use one in a portfolio.

Directional Currency Investing--Hedging Against the U.S. Dollar Risk
Directional currency funds bet on the appreciation or the depreciation of the U.S. dollar (although most actively managed directional currency funds are bearish on the greenback). For example, Merk Hard Currency MERKX and Franklin Templeton Hard Currency ICPHX profit from the depreciation of the U.S. dollar against a basket of "hard currencies" (such as the Swiss franc and the Canadian dollar). Merk Asian Currency MEAFX and Lord Abbett Emerging Markets Currency LDMAX benefit from the weakening of the U.S. dollar relative to developing country currencies. These types of funds serve a unique function in portfolio construction--hedging against a decline in the U.S. dollar.

Stimulative monetary and fiscal policies in the United States, a large current account deficit, and government's exploitation of the U.S. dollar as a tool to boost the economy, all point to a weaker U.S. dollar. As production and manufacturing become increasingly globalized, a falling U.S. dollar imports inflation, which harms U.S. investors by shrinking their purchasing power overtime.

A U.S. dollar bear fund can effectively hedge against inflation risk by holding currencies that stand to appreciate against the dollar. Furthermore, a currency fund has several advantages compared with other popular inflation-hedging tools. First, it does not take on interest-rate or equity risk. Treasury Inflation-Protected Securities on the other hand, have a decent amount of duration risk. For example, iShares Barclays TIPS Bond ETF TIP has an average effective duration of 4.8 years. Investing internationally is another way to hedge U.S. dollar risk, but that method requires investors to take on significant equity risk. In contrast, a currency fund usually keeps duration within 1.0 year and does not invest in any equities, making it a purer play against U.S. dollar risk.

Second, a currency fund tends to be much less volatile than international equities or commodities, two of the most popular inflation-hedging tools. The standard deviation of the inverse ICE USD Futures Index (a currency index that tracks the U.S. dollar against six major developed-country currencies) over the past 10 years is 8.8% (using monthly data), compared with the MSCI EAFE NR USD Index's 18.7% and DS-UBS Commodity Index's 18.1% over the same period.

And finally, currency strategies have low correlations to stocks and bonds, making them better diversifiers than some of the other options. The correlation between the inverse ICE USD Futures Index and the S&P 500 Index over the past 10 years is 0.43, compared with MSCI EAFE NR USD Index's 0.90.

Should an investor decide to allocate a portion to a falling U.S. dollar fund, there are plenty of options. To achieve the desired result, one must choose wisely though. Most currency exchange-traded funds or exchange-traded notes trade single currency pairs, which elevate the country-specific risk to an undesirable level. For example, the CurrencyShares Swiss Franc Trust FXF suffered a sudden reversal last September when the Swiss National Bank intervened. The maximum drawdown for CurrencyShares Swiss Franc Trust reached 15.9% in 2011, nearly twice as much as the diversified inverse ICE USD Futures Index (7.8%). For the average investor, timing the movements of a single currency pair is a next-to-impossible task.