Wed, 9 May 2012
When U.S. policymakers get the 'incentive' from the bond market to address the current deficits, the U.S. dollar may be under far more severe pressure than the euro currently is, says currency fund manager Axel Merk.
Terry Tian: Hi, my name is Terry Tian. I'm an alternative investment analyst with Morningstar. Joining me today is Axel Merk, portfolio manager and president of Merk Investments.
Axel, thank you very much for joining me today.
Axel Merk: Great to be with you.
Tian: There are two major types of currency mutual funds: directional and nondirectional. For example your Merk Hard Currency mutual fund and your Asian Currency fund are both betting against the U.S. dollar, which make them directional, and your Absolute Return Currency fund is a nondirectional strategy. Could you explain the differences between those two types of currency funds?
Merk: Certainly. On the directional side as you point out, it's generally that you buy a currency, a basket of currencies, or in the case of a mutual fund, a managed basket of currencies. On the nondirectional side, you are truly trying to take advantage of the differential moves of any currency for or against the U.S. dollar. Think about buying the Australian dollar and selling the New Zealand dollar. You can't guarantee you'll make money with that position, but almost certainly the returns you generate with that will have a very low correlation to anything else that you are doing. So, with that on the nondirectional side, the primary goal tends to be to generate absolute noncorrelated returns, whereas on the directional side, you can have a play against the U.S. dollar. You can also think about it as international fixed-income investing light, where you're taking on currency risk but trying to mitigate interest and credit risk.
Tian: Axel, you have warned investors of U.S. dollar risk. Could you elaborate on that and why do you think that's a good reason for investors to invest in the U.S. Dollar Bear fund?
Merk: Sure. The good news is that I don't think we have a European crisis. The bad news is I think we have a global crisis. It just happens to be focused on Europe right now. And if there is one thing the policymakers listen to, it is the language of the bond market. Well, in Europe, policymakers are moving because the bond market is telling them to. But the euro, while it's been under pressure, it is not falling completely apart, at least not yet, and the reason is there is no current account deficit in Europe, at least not a significant one. In the U.S. we have a current account deficit, so if and when policymakers in the U.S. get the "incentive" of the bond market to do something about the deficits that we have, the U.S. dollar might be under far more severe pressure.
Now on top of that of course U.S. investors are utterly overexposed to the U.S. dollar. S&P 500 companies hedge about 90% of their earnings back into the U.S. dollar. If you invest in international equities, most of these are large multinationals that are again trying to sell to U.S. consumers. Then importantly, if you use currencies, you don't take on the equity risk. People think currencies are so volatile, but currencies, if you don't use leverage, are actually rather boring. So why take on all this equity risk, when everything is so highly correlated, whereas in the currency space you can try to mitigate some of those risks and you can do that in a very pure fashion by buying a currency, by trying to mitigate the risk of any one currency.
China by the way does the same thing. It diversifies the reserves beyond the U.S. dollar because it knows that any one of these currencies is too risky to hold.
Tian: For the U.S. investors, assets are denominated in U.S. dollars. If they don't invest internationally, how are they getting this currency risk?
Merk: Right now, investors have U.S.-dollar risk. We think that there is no such thing anymore as a risk-free asset, and investors may want to take a diversified approach to something as mundane as cash. The question is how do you take on that risk? How do you manage that risk? Fill out that risk-free component in your portfolio, and by using a currency mutual fund, you can get exposure to a managed basket of currencies. That means you can try to take advantage of the opportunity of hot currencies, Asian currencies, or other currencies appreciating versus the U.S. dollar without taking on significant other risk, without taking on equity risk, while trying to only take on minimal interest or credit risk.
Tian: It sounds like a lot of U.S. investors are overexposed to the weakening U.S.-dollar risk through inflation. What's your opinion on the other types of inflation hedges, such as Treasury Inflation-Protected Securities or commodities? What is the advantage of a currency fund versus those types?
Merk: If you think TIPS are going to protect you against inflation, by all means look no further. We don't think that TIPS are going to be sufficient. Other folks, who are negative on the long-term bond market buy ProShares UltraShort 20+ Treasury. Well, it's very expensive to do that. By buying a currency fund, you can have a play against the declining dollar, while not taking on too many costs for example. If you take a leveraged directional currency exchange-traded, for example, to bet against it, you have to get the timing right. By having a currency fund that doesn't use leverage, you can have a long-term exposure, you can play the ebbs, the in and outs, the data glasses half full, the commodity glass is half empty.
The dollar moves in that context, but if you have looked, every time the pendulum swings back to the U.S. dollar in recent years. It has gone there less so. That's simply because we are better at printing money, and our balance sheet is deteriorating at a faster pace. And secondly, when there is a crisis in the rest of the world, it's being patched up. Not that the rest of the world is safe, but when risk is back on and money moves there, more money stays there than the next time it goes back. And so by using a directional currency fund, you can play that theme while not taking on significant risk that we don't think you need to.
Tian: You just mentioned that a little bit, but I just want you to elaborate on that. So for investors who believe the U.S. dollar will depreciate, why don't they just invest in a currency ETF? What's the advantage of an actively managed directional currency fund?
Merk: The advantage of an actively managed portfolio is that you can try to beat the benchmark obviously. Historically, in the Hard Currency fund, we believe we have done that over just about any time period that one can look at. The world is changing; ETFs also are of course very rigid. Most of them are based on a dollar index which is an index from the 1970s, and that has a 57% euro exposure for example. Well, that might not be ideal even if you are negative on the U.S. dollar. The Euro is less volatile than other currencies, but it has some other challenges as most people are aware of. So we try to add value by having an actively managed basket. I think if there is one thing in this world it's that this active involvement of policymakers does have an impact on the market. But the best place to express that is in the currency world. So by having the active management, by being able to move when policymakers move, we think we might be able to add value, and so as such investors may want to consider that.
Tian: For the nondirectional currency fund. What are the advantages compared with other types of alpha-generating strategies, for example, like an equity market neutral fund?
Merk: We think they might be very complementary. The key difference might be one of liquidity. In a nondirectional currency fund, one should be able to execute in just about any market environment. If you take 2008, a long/short equity fund, couldn't short certain things. So you are dependent on liquidity in the markets is these other spaces much more than the currency space, where you have a more than $4 trillion daily turnover in the currency markets. And so, while of course, you can't guarantee that you make money in that space, one should be able to execute what one wants to execute. And then on top of that, of course, they can be very complementary. Even within the currency space you can have two nondirectional strategies that don't correlate to one another. So any of these strategies might be useful in trying to add diversification in the world where everything is ever more highly correlated.
Tian: So how much do you suggest investors to allocate to those two types of currency funds?
Merk: Well, we are not allowed to give a direct investment recommendation, but we survey others that do and the most common answer we hear is that they'll allocate about 4% to 6% to currencies, those that do. There are some people that allocate much more. Those that do much more really take a more holistic approach. That say "We have to manage the currency risk of everything that we do," and obviously there are different ways of doing it. But 4% to 6% is something that we hear very frequently.
Tian: Thank you very for your insight today.
Merk: My pleasure.
Tian: Thank you.