Diversify equity portfolios with currencies. In contrast to the international stock markets, there are always winners in foreign exchange trading – even in crashes such as during the financial crisis in 2008. Investors who use currencies skillfully in their portfolios can improve their diversification and increase their returns based on risk. This is shown by various studies.
CURRENCIES CANNOT ALL FALL AT THE SAME TIME
But the recent financial crisis dragged almost all assets down. For example, stocks and commodities suddenly fell against each other. During the internet crisis at the beginning of the new millennium, commodities had risen when dividend stocks plummeted.
Of the asset classes that are also accessible to every private investor, only safe government bonds rose in 2008 (which most banks and asset managers had strongly advised against in 2007 due to low interest rates) – and some currencies. Investors from the euro zone were able to diversify their portfolio with Swiss francs (CHF), yen (JPY) and US dollars (USD).
Unlike other investments, there are always winners in the currency markets, regardless of the market phase. That’s in the nature of things: currencies can only be traded in pairs. Their value is always measured in relation to another currency. This relation is expressed by the exchange rates. If the value of one currency in a pair rises, the other must fall. That is trivial. But it makes it clear that diversifying a securities portfolio with foreign exchange can also work in a crisis – provided the right strategy is used.
Lower the risk in the portfolio with foreign exchange
In principle, the risk of mixed portfolios consisting of stocks and bonds can be reduced by adding currencies. This applies both to portfolios that only consist of securities in the home currency of an investor and to international custody accounts, as a number of scientific studies show. The volatility is usually used as a measure of the risk. It is measured statistically with the help of the so-called standard deviation. It indicates how much a variable, in this case the return on a portfolio, fluctuates around its mean value.
Of course, losses cannot be ruled out even with foreign currency in the depot. But they can be restricted. The price for this is a lower absolute performance. Measured against the risk taken, the return increases – the risk-reward ratio of a portfolio improves. A measure that is often used for this is the so-called Sharpe ratio. It sets the portfolio return above the risk-free interest rate in relation to volatility. The higher the value, the greater the return per unit of risk.
Investment specialists differentiate between passive hedging methods and active currency strategies. The latter either follow fixed rules according to which the individual currency positions are regularly adjusted, or a fund manager decides on the basis of an investment model which currencies are bought and sold. Passive positions and active strategies can be combined, which can lead to a further improvement in diversification.
Passive hedging strategies
Most investors have an internationally diversified share portfolio. It is a building block in an overall portfolio. Every investment abroad involves an exchange rate risk, but of course also the chance of additional currency gains. Most investors believe that just spreading the share capital across many countries reduces risk. At first, this also seems plausible. Surprisingly, however, there is no solid evidence for this.
The right currency positions
For mixed equity portfolios from these currency areas, long positions in EUR, CHF and USD and short positions in the other currencies tended to be optimal. A large long USD / short CAD position proved to be a particularly effective diversification instrument. If this currency pair is not available to an investor, the combination long EUR / short AUD is an alternative. These hedging positions work independently of the exact composition of a globally diversified equity portfolio, as tests show. The main reason for this is likely to be the high correlation between international stocks, which in the past rose even further during downturns. Investors who do not have the opportunity to have an optimal strategy calculated by their asset manager, for example, can only use their thumbs to gauge the extent of their currency hedging. Risk-minimizing investors should be well advised with a long USD / short CAD or alternatively long EUR / short AUD position of 50 percent of the equity portfolio. These positions should be checked at least every three months and closed in the meantime if the sign of the correlation should have changed. The best strategy for hedging foreign bonds, on the other hand, is straightforward. They develop relatively independently of currencies. Exchange rate risks should therefore be fully hedged. Another argument for this approach is the high volatility of currencies compared to bonds. In the case of unsecured foreign bonds, currencies contribute up to 95% to the fluctuations in value.