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10 Questions About Currency Investing

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If you're considering investing in currencies, here's what you need to know.

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John R. Baur is vice president at Eaton Vance Management and portfolio manager of the Diversified Currency Income Fund (MUTF:EAIIX).

Why should individuals invest in a currency mutual fund?

BAUR: People are concerned about the future of the US dollar and about the Fed's overly expansive monetary policy.

One way to benefit from that is through exposure to foreign currencies in countries where the central bank is not as aggressively expanding the money supply and where the government executes a better fiscal policy.

There, you can expect better growth and currency appreciation and you can earn local interest rates that can be substantially higher than rates in the US.

Quantify the difference between what you could earn locally versus internationally right now?

BAUR: It varies from country to country. For example, in some Asian countries, interest rates on government-issued bonds are maybe at 2%.

If you look in Latin America, interest rates range from about 4% to as much as 10% in good countries. In Africa-Nigeria and Ghana, for example-interest rates are in the 15% to 20% range-with additional risk, of course.

What exactly is the fund investing in that generates interest?

BAUR: Either through short-term government securities-essentially T-bills issued by a foreign government in its own market and denominated in its own currency-or you're getting that exposure through foreign currency forwards-a contract to buy or sell a specified currency at a specified price on a specific date.

In theory, a foreign currency forward gives you exactly the same risk and return profile as a local-market T-bill.

What are the risks and how do you mitigate them?

BAUR: There's risk that a particular currency could experience a significant devaluation. So where we see that the politics or the economic fundamentals are bad, we try to avoid those currencies.

There's also risk of a broad-based dollar rally when things are going badly in the world because the dollar is a safe-haven currency. Also, foreign currency forwards are an easy way to get exposure to currencies. It takes more effort to invest in the actual government securities.

But these days, the actual securities often yield more than forwards, so you're taking the same risk but for a better return. Thus, buying the actual securities essentially minimizes that risk.

Settlement of securities can also involve risk. Our trading desk operates 24 hours a day and trades directly in local markets to get the best prices and avoid that risk.

Is there a "best" currency to be invested in?

BAUR: In the long run, currencies tend to be driven more by growth prospects. So in a multiyear horizon, we think many countries have better growth prospects than the US. That's what drives currency appreciation over the medium to long term.

Mexico, Peru, India, Malaysia, and Sri Lanka are very attractive. Sweden, Serbia, and Norway are also good. We're trying to provide broadly diversified currency exposure. Our fund policy is to keep all country exposures under 5%.

We also limit exposure to the euro. Most currency investors actually have very large explicit or implicit euro exposure. We don't. We trade western and eastern European currencies versus the euro, which has the effect of significantly reducing volatility in our fund.

As an investor, is it difficult to essentially create my own currency fund?

BAUR: Even for sophisticated individuals, currency instruments can be complicated. Given our experience, they're simple, but in conversations I've had, it's clear that something as simple as a foreign currency forward is not well understood. The learning curve is steep.

In addition, to buy short-term government securities, you need to open an account in every country in which you want to purchase these securities. That's a significant logistical hurdle.

Keeping track of political and economic events in countries around the world is also more difficult than paying attention to what's going on in a stock portfolio.



How much of an investor's portfolio should be in currencies?

BAUR: Investors are systematically underweight in foreign currency exposure. Today, you would want to have between 10% and 20% of your portfolio invested in foreign currency denominated instruments.

In the traditional 60% equities and 40% fixed income portfolio, between ¼ and ½ of the fixed income portion should be in foreign currencies. If the Fed funds rate were at 5%, then I would back off my currency exposure to the 5% to 10% range.

How can an investor evaluate a currency fund?

BAUR: It's not straightforward, partly because currency funds are relatively new, and different managers do significantly different things.

Some focus exclusively on G10 currencies like the euro, the yen, and the British pound. Others focus on emerging markets currencies. Some, like us, invest across the universe.

So, first of all, understand what the fund's investment universe is. Then understand the managers' investment styles.

Are they short-term traders who are likely to have relatively volatile funds, or are they long-term investors who are trying to manage the volatility and benefit from longer-term trends?

Finally, what returns has the manager produced given the risks?

[Editor: Over the last one-, three-, and five-year periods, the fund has earned 6.05%, 2.05%, and 5.24%, respectively. In contrast, the Barclays Capital Global Ex-USD Index has returned 1.89%, 1.46%, and 1.33% over the same periods.]

What's your best advice for someone who wants to invest in currencies?

BAUR: Buy a currency fund. You need exposure to foreign currencies. Your currency exposure should be managed rather than passive.

The currency space has significant inefficiencies you want to take advantage of. Those inefficiencies create opportunity for active managers to make profits.

You won't benefit from those inefficiencies if you take a passive approach to currency investing.

What attracted you to this investment style?

BAUR: It brings together three things that I'm passionate about. It's economics, politics, and geopolitics all wrapped up in one.

Every day I come to work and get to study what's happening around the world. I feel privileged to be in a position to do that.

Editor's Note: This article by Gregory Taggart was originally published on MintLife.

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Twitter: @mint
No positions in stocks mentioned.
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