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Currency Diversification for a Reasonable Price

Foreign-currency exposure to protect against a declining U.S. dollar.

Mallory Horejs, 06/14/2012

Franklin Templeton Hard Currency ICPHX aims to shield investors from U.S. dollar depreciation by investing primarily in "hard" currencies (defined by management as those of industrialized, politically stable countries) that appear undervalued relative to the greenback. Because most investors are overexposed to the U.S. dollar through their income stream and portfolio assets, a currency strategy like this one can add significant value. So far, manager Michael Hasenstab has proved that this fund is a solid option--its three- and five-year annualized returns outpace both the category average and inverse ICE USD Futures Index (which tracks the U.S. dollar's inverse performance against six major currencies) by a wide margin.

To produce these attractive returns, Hasenstab relies on the analysis of Franklin Templeton's seasoned research staff (who also supports the 5-star Templeton Global Bond TPINX. Based on the staff's recommendations, he constructs a concentrated portfolio of major currencies using short-term bonds and forward contracts. The South Korean won and Australian dollar, for example, have been the portfolio's two largest positions for several quarters, constituting 15.5% and 13.3% of assets, respectively (as of March 2012). Management believes both currencies are well poised to benefit from China's continued growth. The team maintains a longer-term outlook (two to three years) on its currency positions in order to overcome any short-term volatility. Another distinguishing feature, one that has allowed this fund to outperform so far relative to other currency funds and relative to the inverse U.S. dollar index, is the absence of the euro--Hasenstab moved out of the euro in early 2008 based on his concerns regarding the highly indebted peripheral eurozone countries.

As with any directional currency strategy, this fund's performance depends on the weakening of the U.S. dollar. But for investors willing to take that bet, this offering can be had for a great price--its 1.05% expense ratio falls well below the category average.

Undervalued Foreign Currencies
The fund aims to profit from a decline in the U.S. dollar by buying foreign currencies best positioned to appreciate against the greenback. Management uses short-term, high-quality sovereign bonds and currency forwards to express its views. To identify undervalued currencies, management looks for countries with strong economic growth, improving trade balances, and fiscal discipline. The fund doesn't use leverage or take short positions in currencies, nor does it take on credit or duration risk with its collateral, which is invested in U.S. Treasury bills.

Management adheres to a three-step portfolio construction process. First, it looks at fundamental long-term currency valuations (determined through macroeconomic research and various forms of exchange rate analysis). Next, it focuses on short-term dynamics that can drive currencies from their long-term equilibrium values (real and nominal interest rates, relative growth and productivity rates, and balance of payments, for example). Last, it conducts a scenario analysis to model potential shocks (geopolitical risks, commodity prices, and so on) on currency values.

When all three levels of analysis indicate that a given currency is undervalued relative to the U.S. dollar, management will include it in the portfolio. Position sizes are determined by each foreign currency's risk/return profile, and exposure to a single currency cannot exceed 50% of total assets. The fund focuses mostly on developed-markets currencies, but management can and does invest up to 20% of its net assets in emerging-markets currencies.

As of March 2012, the portfolio was invested in 16 currencies. The largest allocations were to the South Korean won (15.5%), the Australian dollar (13.3%), the Singapore dollar (13.0%), and the Canadian dollar (12.0%). Unlike many currency funds, this one does not currently invest in the euro.

Consistent Outperformance
Evaluating actively managed currency funds is difficult because most have short histories--although Michael Hasenstab has managed this fund for over 11 years, only one of its peers has a comparable history. As a result, peer rankings from 2002 to 2005 that show this fund as the category's worst performer are misleading. In reality, both offerings posted strong annual returns over this period.

Over the last five years, however, the peer group is more robust, and Hasenstab has clearly outperformed. His 4.20% five-year annualized return and 0.38 Sharpe ratio both rank in the category's top decile (using monthly data through April 2012). The fund's performance over the one- and three-year periods, although less impressive, is still slightly above average.

The fund can also be benchmarked against the inverse ICE USD Futures Index, which tracks the U.S. dollar's inverse performance against six major developed currencies. As an actively managed strategy, this fund's currency selection and weighting significantly differ from the index, though, most notably through Hasenstab's decision not to invest in the euro, which constitutes 57.6% of the ICE USD Index USDX. So far his more-diversified approach has paid off--the strategy's 5.93% annualized return since Hasenstab started running the strategy in January 2001 outpaces the inverse U.S. dollar index by over 3% (using monthly data through April).

Seasoned Management
Michael Hasenstab has run this fund for over a decade. He joined Franklin Templeton in 1995 as an emerging-markets sovereign credit analyst, left to get a Ph.D. in economics, and rejoined the firm in 2001. Sonal Desai, who previously conducted macroeconomic research at hedge fund Thames River Capital, joined the group as its research director in late 2009. She became a comanager in March 2011. Although manager ownership in this fund is low, Hasenstab has over $1 million invested in Templeton Global Bond TPINX, which contains a currency sleeve managed to a similar mandate.

Mallory Horejs is an alternative investments analyst with Morningstar.
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