Currency Investing Can Add Alpha to Your Portfolio
While you may be getting low-to-decent returns in the equity market, using a currency strategy as part of your portfolio may help generate more cash to your bottom line. You can add a little alpha without adding a lot of risk.
One of the primary reasons to consider using currencies in a portfolio is because the capital markets are moving in lock step.
Equity markets are so highly correlated — better than 80 percent in fact — it's almost impossible to achieve diversification. That's where adding some exposure to the currency market can help. Currencies are another way to achieve diversification, because each currency trades on its own underlying economic and political fundamentals, and rarely moves in lock step.
There may be some overlap — for instance, both the dollar and the euro may move on events in Europe — but the dollar primarily moves on the economic and monetary events in the U.S., and the euro on the events in the euro zone. (Read More: Currency Playbook for the 'Fiscal Cliff.')
Marc Chandler, global head of currency strategy at Brown Brothers Harriman, said the addition of currency to a portfolio of global fixed income can be worth two-thirds of the return over time. Likewise, with an international basket of stocks, currency can amount to one-third of the return over time. So, adding a currency component is not meant to replace exposure to the equity or fixed income market but rather to augment it.
Many investors now play the currency markets through the use of exchange traded funds. (Learn More: ETFs.) Chandler points out that the currency market, which is the biggest in the world, trades 24 hours a day; therefore, if you are using an ETF for currency exposure, you are captive to normal trading hours and are missing one third of global trading. If a news event happens overnight, your portfolio is going to react after the news event. (Read More: Investing in Currency ETFs.)
You can also use futures to get exposure to the market or various electronic platforms. However, Chandler cautions that many of these electronic platforms contain models that actually have bets that are opposite of the firm's clients. In essence, they are betting against you.
If you are interested in taking the plunge, here are some of Chandler's favorite currency plays right now.
If you want exposure to Asia, consider playing the Japanese yen. The Japanese stock market is highly correlated to the yen. Historically, when the yen weakens, the Japanese stock market goes up.
The Bank of Japan desperately wants the yen to weaken, which would help exports and thus stimulate its ailing economy; Chandler thinks it's a pretty safe bet that the central bank will continue to be very loose with monetary policy.
Chandler's play would be to buy the Nikkei in dollar terms and sell the yen. If you had put that trade on, you'd be up better than 3.5 percent year to date. Not a huge return certainly, but a nice addition to any portfolio.
As he points out, one part of each trade is likely to be correct, and can help you weather the market storm with a little extra cash in that portfolio.