taThe foreign exchange market is among the largest and most liquid markets in the world. Currency is often overlooked as an asset class, and instead viewed only in its more familiar role as a common medium of exchange. Among U.S. investors, whose lives have rarely been exposed to currency fluctuations, the luxury of economic scale and the ease of geographic continuity have helped to reinforce a passive attitude toward currency.

This is in stark contrast to the historical experience of many Europeans and other people subject to frequent cross-border transactions. But, domestic reality is changing rapidly, as Americans find their cost of living and economic prospects buffeted by forces well beyond U.S. borders. Equally important, the impact of currency changes on investment portfolios is undeniable, as is the value of exploring this facet of asset allocation.

Depth and Breadth

The daily volume and total value of foreign exchange trading is greater than the totals seen in the equity markets. They even dwarf the level of global GDP. The influence of currency movements is felt throughout the real economy and ultimately impacts equity returns, interest rates and real asset pricing.

Given that client portfolios are exposed to currency fluctuations in a very broad manner, should advisors consider actively managing this phenomenon or simply accept it as unavoidable? Let's review a few examples of how relative currency values can affect portfolio holdings, and explore some strategies that allow more engagement with this aspect of investment management.

While many investors accept the idea that international stocks have a legitimate place in diversified asset allocation, few understand the overriding influence of currency on non-U.S. equity returns.

Take the well known MSCI EAFE index (Europe, Australasia, Far East) as an example. The annualized return of the index as viewed by U.S. investors for the 10 years ending July 30, 2010 was 1.9%. This fairly modest, absolute level of return is more impressive when compared to the -0.8% annualized loss turned in by the S&P 500 Index over the same time period.

Investors may believe that more favorable foreign economic growth and corporate profits led to this comparative gain. But, the reality is quite different. The depreciation of the U.S. dollar over the past 10 years was responsible for the pickup in the returns attributed to EAFE. Without a boost from foreign currency appreciation, U.S. investors would have seen the same 10-year return as local investors in the equity markets that comprise EAFE. And this return was virtually identical to that of the S&P 500.

One number does not adequately capture a decade of comparative investment performance, but it does serve to illustrate the potential impact of foreign currency relationships on investor results.

Much uncertainty clouds the future path of the global economy and currencies, with fundamentally driven secular views grappling with flight-to-quality sentiment. And, with the proliferation of specialized funds and exchange-traded funds, investors may ask whether a more tactical approach to currency is warranted.

An Active Decision

Assuming an allocation to EAFE markets and a favorable view on the dollar as an example, it is possible to reduce the embedded currency bets of the index through the use of inverse currency ETFs, or with a U.S. dollar bull ETF against a basket of non-dollar currencies. This is tricky business with significant tracking error and expenses to boot. Inverse ETFs expose portfolios to the well-publicized complications of leverage used over multi-day time frames, and the menu of inverse currency ETFs offers very few options to begin with. The choices expand if short selling "normal" currency ETFs is considered, and this may be the better path for managing periodic currency flight risk, such as the Greek debt-inspired euro plunge of this past spring (naysayers are free to point to the eventual bounce back of the euro.)

Currency-hedged international equity index ETFs have also come on the scene. These are a viable option for investors who want foreign stock exposure while sidestepping the direct impact of currency. Current indexed offerings are limited to funds whose constituent holdings are weighted other than by market capitalization.

Here again, investors would be making an active choice-away from a passive index exposure in this case-avoiding some of the momentum inherent with capitalization weighting.

There are many international equity mutual funds offering active management combined with currency risk hedged back to the U.S. dollar. Obviously, the underlying companies whose stocks are held in a fund will be affected to a varying degree by trends in foreign exchange.