Is Currency an Asset Class? -- Seeking Alpha http://seekingalpha.

com/article/24850-is-currency-an-asset-class

by: Richard Shaw

January 23, 2007 | about: FXB / FXE

There is a lot of action in the currency markets as this chart of the exchange rate between the USD and the EURO shows,
and there is effectively no correlation between currency markets and U.S. stocks. But is currency an asset class?

[click to enlarge]

In its 2005 annual report, the Yale Endowment said:

Because investment management involves as much art as science, qualitative considerations play an
extremely important role in portfolio decisions. The definition of an asset class is quite subjective, requiring
precise distinctions where none exist.

Hedge fund managers sometimes say, “If it moves up and down independently, then it’s an asset class.”

In 1999, William Bernstein (author of “The Intelligent Allocator”) said on his Efficient Frontier website, “In the long run,
currency exposure reduces overall portfolio risk, and probably increases return.” He was referring to exposure within
foreign stocks.

In 2001, Kathy Mann, Director of the Office of the Fiduciary Advisor at State Street Global Advisors wrote an article titled
“Currency as an Asset Class” which said:

Active currency in portfolios is used in two primary ways. Either via an active overlay to a plan's international
exposures or by taking on currency as a separate or alternative asset class … However for all intents and
purposes, active currency has zero correlation to the major equity and fixed income asset classes. … In the
search to add non-correlated series to achieve diversified returns, active currency can play a significant role.

The Alliance Bernstein website reviewed the 20 years for 1981 - 2001 and said "there’s effectively no correlation between
the movements of foreign currencies and U.S stocks."

In 2003 Russell published a study titled “Is there still Alpha to be gained in active currency management?” That study said
there is alpha to be obtained and that the alpha opportunity should persist, because the great majority of currency market
participants take positions for commercial account settlement purposes and not for trading profits.

Deutsche Bank, one of the world’s major currency market makers places these promotional words on its FX website:

Diversify Your Portfolio with Foreign Exchange Investments. The foreign exchange markets offer investors
the opportunity to diversify their portfolios from stock and bonds. Investors who diversify their portfolios, by
including foreign exchange as an asset class, can lower the overall volatility of their portfolio. Stocks or
stock indices even when varied by country or industry in your portfolio tend to move in synch.

Certainly, those sponsors of currency ETFs and currency mutual funds believe there is a market for individuals to invest
directly in currencies.

Institutional portfolios tend to have a category labeled “alternative investments”. It seems to be a way to justify a wide and
varied range of assets and investment strategies, but it tends to include hedge funds many of which tend to invest directly
in currencies.

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Is Currency an Asset Class? -- Seeking Alpha http://seekingalpha.com/article/24850-is-currency-an-asset-class

So, is currency in its direct form (foreign exchange for FX holdings) something individuals should consider as an
asset class for their portfolios? If yes, how?

Not as Exotic as You Think

We find it intriguing that currency is considered to be exotic by so many. After all, everything we do is in some way
impacted by currencies. With global business, material and human resources from different countries are poured into the
products we buy effecting basic economics for individuals and corporations.

The currency markets are the largest markets in the world by definition, since every other market is denominated in
currencies. Daily global trading in currencies approaches $2 trillion, dwarfing any stock or bond or futures market.

Approximately 85% of world FX transactions are denominated in six major currencies against the U.S. Dollar; Euro, Yen,
British Sterling, Canadian Dollar, Swedish Krona and Swiss Franc.

It is interesting to note that while it is theoretically possible for stocks, bonds and commodities to all fall in price at the
same time, it is not theoretically possible for all currencies to fall at the same time, because the value of currencies are
expressed in terms of other currencies. If one goes down, another must go up.

We don’t know yet how we feel about currency as an asset class, but we do have a pretty good idea about how to add
direct currency exposure to an individual portfolio.

Currency For the Individual Investor

Institutions and large commercial enterprises have more options than individual investors, because some methods of
taking on currency positions require very large financial transactions. Those are generally in what are called “forward
contracts”

U.S. investors used to be able to open offshore or other foreign bank accounts to hold deposits denominated in
currencies other than the U.S. Dollar, but that avenue is effectively killed off by banking rules implemented since the
terrorist attack on the World Trade Center on 9/11 to prevent funding of other terrorist activities.

Individual investors generally have these options today:

• Currency futures
• Currency investment funds
• Currency spot accounts

These three options are substantially different. What suits one investor may not suit the other.

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* Investor assets in futures accounts and brokerage accounts are not general assets of the dealer or the investment
advisor and are not at risk in the event of the bankruptcy of the dealer or advisor. Spot currency assets are general
assets of the bank or dealer, and are at risk in the event of the bankruptcy of the bank or dealer. If you do spot currency
FX trading, be sure to use large, solvent, reputable banks if possible (for example, Deutsche Bank offers online retail
FX trading).

** FX trading is 24 hours per day, 365 days per week. However, there are quiet trading periods where trading is thin (such
as from evening Fridays to evening on Sundays) during which the retail FX trading service desks tend to be closed.

***Interest earnings with currency trading can be positive or negative. For example, the difference between the
government overnight rates of the two countries of the trading pair is calculated and either credited or debited to the
traders account each day based for trades held overnight.

Futures contracts have the advantage of offering trading of the U.S. Dollar against a basket of the six major foreign
currencies in what is called the US Dollar Index.

The US Dollar Index is weighted as follows:

• Euro 57.6%
• Japanese yen 13.6%
• UK pound 11.9%
• Canadian dollar 9.1%
• Swedish krona 4.2%
• Swiss franc 3.6%

For our own purposes, we use spot trading accounts because of the very low trading costs. Typical trading costs are in the
range of 3/100th of 1% to 4/100th of 1% compared to the continuous asset management fees of 0.40% to 1.68%
associated with a currency fund.

Currency Funds:

Rydex offers several ETFs that hold single currencies as their only investment.

As you can see, these currency ETFs do not have liquid trading and are not suitable for most purposes at this stage of
their adoption by investors. Only FXE has any reasonable potential for use, and that is not great. Compare the 40,000
average daily shares of FXE to the 57 million average daily sharers of SPY. We would use 100,000 shares as a daily
minimum for ETFs to be considered.

There are also currency mutual funds, but the costs are significant. For example,

• Templeton Hard Currency [ICPHX]; 2.25% sales charge; 1.13% expense ratio,
• Merk Hard Currency [MERKX]; no-load; 1.30% expense ratio,
• ProFunds Falling Dollar [FDPIX]; no-load; 1.50% expense ratio,
• Rydex Dynamic Weakening Dollar [RYWBX]; no-load; 1.68% expense ratio.

Overall, we feel that currency futures or spot trading accounts are the way to go at this time for retail investors. We prefer
spot trading accounts through a major bank due to better execution and lower trading costs, which we obtain by taking the
bankruptcy risk of the bank.

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Mark Hartman

Care to comment of DBV, the BD G10 Currency Harvest ETF?

www.dbfunds.db.com/Dbv...

QVM Group

Fair question. My real goal was to talk generally about allocation to currencies as an asset class.

DBV is an active management multi-currency fund, as are one or more of the mutual funds I cited in the article. I
probably should have left them out. They are there to show massive differences in expense ratios, between mutual
fund and ETF alternatives and to be fair in listing different avenues for investors to enter currencies, not to compare
active and passive management, or to compare single or multi-currency approaches.

I think the problem of whether currency is an asset class is easier to address conceptually, initially by looking at
single currencies or a basket index, as opposed to actively managed multi-currency funds. Discussing currencies as
an asset class and active management at the same time brings two sets of arguments together that could
overshadow the core argument -- that currency may be an asset class.

There are those who believe in allocation via passive indices and those who believe in allocating via active
management. That is a question that is beyond this article and not something that I wish to tackle. I think it is well
handled elsewhere.

If you wish to make a return comparison, you might begin by comparing the return on active management currency
funds to the US Dollar index, a trade weighted passive basket of the six major non-US currencies. That would be
roughly equivalent to comparing a particular actively managed US equity fund to the S&P 500.

gmarcos

Thanks for the article. Wouldn't back-testing various asset allocation models with some portion allocated to
currencies help answer the question regarding it's value in a portfolio? Are there any studies on this subject?

The counter arguments I've heard is that you are hedged against currency fluctuations if you own a balanced portfolio
(say 50% of your Equity Portion in International Equities). Even the portion of a U.S. stock portfolio is heavily
weighted in companies that are doing international business. Thus, it evens itself out in time.

Lastly, what portion of a portfolio should be treated in this way?Would one consider it a portion of your fixed
allocation or would it be a different class completely like REITS or commodities?

Thanks

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