The Dollar Armageddonists Might Have a Point
How multicurrency funds can help.
Fund Spy
The dollar arguably isn't the world's reserve currency by choice. Remember the telephone industry when it was monopolized by AT&T, cable television before satellite dishes appeared, or Microsoft Windows® prior to Apple's resurgence? Consumers were not always satisfied with their limited options, but they had to make do. Similarly, America's adversaries, as well as some of its allies, gripe about their over-reliance on the greenback. But right now, there really is no competition.
As with most monopolies, though, eventually the market's (and sometimes the government's) hand can force change, and dollar doomsayers' prophecies may play out. There are serious risks related to the greenback that investors should be cognizant of, and diversifying into other currencies seems like the most rational solution.
It's the Only One ... For Now
There are about $1.2 trillion U.S. dollars in circulation, the majority of which lie outside our borders, according to the Reserve Bank of New York. Foreigners own approximately half of the U.S. debt--the top owners being foreign central banks who flock in droves to the world's only reserve currency.
The dollar currently makes up 62.2% of the world's foreign exchange reserves. Although this number is below its peak of 71.0% in 1999, it's still above where it stood in 1995, at 59.0%.[1] By contrast, the euro makes up 23.7% of foreign reserves, and no other currency comes close. As a liquid and stable store of value, no other currency, asset class, or bitcoin can compete. One major contributing factor is its sheer market size. Take gold, of which there is only a finite amount--in 2011 only an estimated $125 billion was mined.[2] The market for publicly held U.S. Treasuries, however, is an enormous $11.96 trillion.[3] At the moment, every major country--even our staunchest opponent--owns a piece of the pie. Although China owns the most ($1.27 trillion), other world players also have a large stake: Brazil ($252.9 billion), Taiwan ($183.6), United Kingdom ($159.1), and even Russia ($136.0).[4] And history has shown that there is typically only one reserve currency at a single time, usually that of the current superpower.
Not the First
Just as America wasn't the world's first superpower, the dollar wasn't the world's first reserve currency. Historians believe the silver drachma was the first in the fifth century B.C.E.[5], but the pound sterling is the most recent to precede the dollar. It comprised about 60% of global trade between 1860 and 1914. It wasn't until after the Bretton Woods system was established in 1945 that the buck rose to importance.
The transition away from the Sterling to the U.S. dollar wasn't easy. Countries moved at a snail's pace, even as the British government tried to undermine its own reserve status. In 1955, 10 years after Bretton Woods, the pound still made up 50% of currency reserves. Finally, by 1970, Sterling reserves fell below the 20% mark and petered off dramatically in subsequent years.[6]
Does the World Need a Reserve Currency?
Economists wrangle back and forth on why the world needs a reserve currency. The most widely cited reason is the so-called network effect. As more people join the social-networking site Facebook, for example, the website incentivizes more people to join; the more who join, the more useful to its users. If more people transact in a single reserve currency, the widely accepted theory is that markets become less expensive and more efficient. Not everyone agrees with this theory, however. UC Berkeley's Barry Eichengreen, for one, argues that the dollar's reign may be coming to an end, and others argue the key ingredient in unpinning the dollar is none other than advancements in technology.[7]
If the dollar falls out of reserve status, it's tough to predict what comes next.[8] In 2008, Greenspan wrote that it's "absolutely conceivable" that the euro could replace the dollar's status as the world's currency, or be its equal.[9] He said this, of course, before the financial crisis took its toll on Europe. Because there is so much uncertainty, investors can protect themselves by diversifying into a multicurrency fund.
Multicurrency Funds
There are two primary types of multicurrency mutual funds: those that are short the U.S. dollar against a basket of currencies, and those that trade non-U.S. dollar currency pairs, such as the euro versus the yen. (Because all currencies are traded in pairs, if an investor buys one, he must sell another). Short U.S. dollar funds are typically actively managed and invest in highly liquid currency forwards or short-term government debt of foreign countries according to management's macroeconomic view of currency valuations. These funds profit when the dollar falls. Nondirectional currency funds do not always take a particular point of view on the U.S. dollar. These funds employ strategies such as valuation, carry (long the high-yielding and short the low-yielding currency), and momentum (price-trend following). These funds hope to profit regardless of what happens to the U.S. dollar.
Two standout short-dollar mutual funds are Silver-rated Merk Hard Currency and Franklin Templeton Hard Currency . The term "hard" generally implies that management looks for countries with strong economic outlooks and reliable central banks. Generally, investors can benchmark these funds' returns to the inverse U.S. Dollar Index or the PowerShares DB US Dollar Bearish (UDN) exchange-traded fund, which tracks the futures on this index. (There really aren't many multicurrency choices in exchange-traded vehicles.) Investors should note, however, that these benchmarks' portfolios are constructed using outdated relative trade weights within the G-10. Subsequently, 57.6% of the ETF's assets are invested in euros. Conversely, Merk's portfolio held only 45% in the euro, while Franklin's portfolio allocated 0%. The Merk fund is a good choice because it eschews index-hugging and focuses on long-term fundamentals, and the Franklin Templeton fund is run by a solid management team.
Morningstar has not assigned any positive qualitative ratings to nondirectional U.S. dollar funds, but Merk Absolute Return Currency is one example. The fund uses forward contracts to wager on "cross" currency trades, such as the euro versus the yen, or Canadian dollar versus the New Zealand dollar. Among other things, management's process is based on currency momentum and carry trade returns. Neutral-rated Columbia Absolute Return Currency & Income is similar, but the fund's process is more systematic.
Emerge Into the Emerging
If investors are looking for juicier returns, they might consider emerging-markets currency exposure. PIMCO manages Silver-rated PIMCO Emerging Markets Currency PLMAX, which invests in short-term, emerging-markets government and corporate debt. As of Sept. 30, the fund was heavily exposed to China (10.1% in mainland and 9.7% in Hong Kong currency) but also has substantial positions in Russia (9.1%) and Mexico (9.0%). Emerging-markets currencies have more volatility than those of developed markets. In 2008, for example, investors yanked money from the fund, forcing the management to sell its bonds at extremely depressed prices. That year, it lost 14.9%, compared with a loss of only 4.9% for the Merk Hard currency fund and a 1.1% gain for the Franklin Templeton Hard currency fund. This year, the fund has lost 1.6%, compared with a gain of 0.6% for the MSCI Emerging Market's index (through October).
Putting It in a Portfolio
Because currency funds have risk-return profiles most similar to bond funds', it makes sense to allocate to currency funds out of one's bond allocation. Allocating 5% to the PIMCO, Merk, andFranklin Templeton funds mentioned above, from the 40% of a typical 60-40 portfolio (60% S&P 500 and 40% Barclays Aggregate Bond Indexes rebalanced quarterly), would have led to slightly worse absolute and risk-adjusted returns, because bonds have been on a tear. As the outlook for bonds is not nearly as rosy as it has been in the past, and the dollar is also facing troubles, diversifying into a topnotch multicurrency may be just the solution.
[3] http://www.treasurydirect.gov/govt/reports/pd/mspd/2013/opds092013.pdf
[4] http://www.treasury.gov/resource-center/data-chart-center/tic/Documents/mfh.txt
[5] http://www.zerohedge.com/article/history-worlds-reserve-currency-ancient-greece-today
[7] http://online.wsj.com/news/articles/SB10001424052748703313304576132170181013248
[8] http://www.businessinsider.com/timing-the-inevitable-decline-of-the-us-dollar-2011-1
[9] http://www.reuters.com/article/2007/09/17/greenspan-euro-idUSL1771147920070917