Dramatic currency moves topped the financial news in early 2014. The Argentinian peso and the Russian ruble plunged, while Coke reported lower-than-expected earnings, partly attributed to weaker international currencies.

In the United States, most investors are exposed to foreign currency fluctuations in their portfolios, either through stakes in global companies like Coke or direct ownership of foreign assets including stocks, bonds and real estate. According to the Investment Company Institute, over $1.5 trillion, or 12% of U.S. mutual fund assets, was invested in global equity funds at the end of 2012, and most advisors consider looking overseas for greater diversification and returns for their clients.

But how should advisors protect their clients from currency exposure? Institutional investors commonly hedge currency exposure with forward contracts, an option not easily available to individual investors who have historically had to ride out currency fluctuations. That dynamic is changing, however, and individuals now have the option to participate actively in currency investing or to greatly reduce their exposure from international investments.

Avoiding Currency Risk

New funds offer investors a chance to buy stocks or bonds overseas without currency exposure. Vanguard's Total International Bond Index Fund (offered as both a low cost mutual fund and as an ETF) has attracted $18 billion in assets since it opened its doors in June of 2013. The fund invests in high-grade bonds in developed and some developing nations, but hedges out currency risk. Fees for the mutual fund tick in at a low 0.23% annually and the SEC yield is 1.5%. Like any bond fund, VTIBX faces credit and interest rate risk. But by inexpensively hedging out currency risk, the portfolio's managers eliminate the added uncertainty of currency swings.

Wisdom Tree's Japan Hedged Equity (DXJ) Fund, meanwhile, was well positioned when Japanese policy-makers began aggressively pushing for greater economic growth in late 2012. The fund (which has a 0.48% annual management fee) gained 40.9% in 2013, fully participating in the local gains of the Japanese stock market without experiencing the 20% drop in the value of the Japanese yen. DXJ has almost $12 billion in assets.

The success of currency-hedged equity funds like these has drawn more entrants. For example, BlackRock's iShares launched three currency-hedged equity funds in February.

Embracing Currency Exposure

But what if, instead of wanting to eliminate currency risk, a client seeks to diversify out of the U.S. dollar into other currencies? Once an option only for futures traders or Swiss bank account holders, individuals can now express their views on the relative value of the U.S. dollar in almost any fashion.

One popular way has been through gold ownership, viewed as the ultimate defense against inflation resulting from easy monetary and profligate fiscal policy in the United States. "Gold is the ultimate hard currency," says Axel Merk, president and chief investment officer of Merk Investments. Indeed, the Merk Hard Currency Fund, MERKX, had a 14% allocation to gold at the end of 2013, its second largest position after the euro, which comprised 44% of the portfolio.

Merk Funds specialize in currency investing, and its Hard Currency Fund is one of only two currency funds rated silver by Morningstar, which doesn't award a gold rating to any of the funds in this category. "What we do is fundamental analysis on a macro level," Merk says. "Most investors are overexposed to the United States. International stocks are one answer but are not true diversification. Currency has a low correlation to other investments." And despite perceptions to the contrary, currencies have low volatility (see chart).

Investors in gold, however, received a sharp rebuke in 2013, not uncommon with this volatile commodity. GLD, the popular Gold ETF with $30 billion in assets, fell from $161 to $116 in 2013, a 28% drop. The Merk Hard Currency Fund lost 5.4% for the period because of its diversified currency mix.

"Investors are just not that enthused about these currency strategy funds," says Michael Rawson, passive-funds analyst at Morningstar. He points out that assets in pure currency funds remain small compared to other asset classes, totaling just over $14 billion at the end of 2013, and haven't experienced steady growth in popularity. However, Rawson acknowledges that "cash or money market positions in a basket of hard currencies does allow diversification out of the U.S. dollar and is a relatively safe investment."

"A Renminbi in Every Pocket"

Where are advisors and investors looking now for a currency with long-term prospects to the upside? How about the world's second largest economy? According to the London-based Center for Economics and Business Research, China will overtake the United States as the world's largest economy in 2028, and as Chinese officials slowly loosen their stranglehold on the domestic currency, more options for investing in renminbi-denominated assets are opening up.

Last year in a white paper entitled "A Revolutionary Idea: A Renminbi in Every Pocket," Edmund Harriss, investment director and fund manager at fund company Guinness Atkinson, wrote: "While it may seem revolutionary at the moment, we believe that over time it will become common practice to hold assets — including cash — denominated in the renminbi."

The renminbi is the name of the Chinese currency like British sterling, while the yuan is the unit of currency like the British pound. The Guinness Atkinson Renminbi Yuan & Bond Fund, GARBX, invests in a range of primarily high grade bonds with maturities one to five years out and yields 2.5% while participating in any potential appreciation in the Chinese currency. It has a $10,000 minimum investment and a 0.92% expense ratio. GARBX rose 5.26% in 2013, compared to Vanguard's U.S. Intermediate Term Corporate Bond Index ETF (VCIT), which fell 6.12% during the same timeframe.

Renminbi-denominated bonds in the offshore market, nicknamed "dim sum" bonds, currently total a miniscule $60 billion. Yet Harriss, who has been investing in Hong Kong and China since 1994, suggests that over the next decade, investors might see the Chinese yuan increase by about a third in value, going from around six yuan to the U.S. dollar to four to the dollar

"The currency's propensity to appreciate is affected by China's greater economic growth and rate of increase in standard of living relative to the United States," Harriss argues. But a slew of potential dangers include higher interest rates, potential price inflation, social unrest, economic and political policies, counter-party risk and credit risk.

To date, currency trading and long-term investing have remained a specialized corner of the investment world; Morningstar analyst Rawson thinks maybe it should stay that way. "Currency is the playground of large money center banks and governments," he says. "It is not necessarily the best fund arena."

But in our globalized world, the role of foreign currencies in investment returns has become hard to ignore. An ever-growing array of products allows advisors to help clients manage risk and find new opportunities.


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