June 18, 2012 / 4:01 PM / 5 years ago

COLUMN-Four currency strategies for euro/dollar angst

5 Min Read

By John Wasik

CHICAGO, June 18 (Reuters) - Developing a currency strategy for your portfolio is like playing a chess game in which the pieces are the futures of entire countries. Will Greece be able to form a government and get its act together to keep the euro? What about Spain and Italy? With the embattled euro and dollar under a perennial cloud, does it make sense to have currency strategy for your portfolio at all?

If you're heavily invested in the securities of one denomination, adopting a currency hedge may make some sense, although the direction of currencies is notoriously difficult to predict. All denominations are subject to political risk, the economic health of the countries backing it, inflation and interest rates. And currencies don't pay a quarterly dividend like a stock can or have a fixed coupon like a bond. Their values are determined relative to other currencies and vary depending upon a number of economic measures. It's a complex and volatile brew.

Then, there's always a concern about currency debasement, or the fear that countries are printing too much money, which in turn stokes inflation. While that's not an immediate concern in the U.S. or Europe now, it could be if those economies heat up again. And it could be that conventional wisdom about a currency's decline will be wrong long term.

"I see a happy outcome for the euro," says James Rickards, a senior managing director with Tangent Capital in New York and author of "Currency Wars." "The Greeks want the euro. It will come in for a soft landing."

There are a number of ways to invest in currency movements, although it's unlikely that you can beat large institutions or sophisticated trading programs in this $4 trillion daily market. While it's highly risky, there are some indirect ways of benefiting from currency gains. The best way to adopt a currency strategy depends upon how much risk you want to take and what you need to accomplish. Here are four approaches:

1. Go long on a single currency.

This is where you wager that one currency will do better than another. You're subject to timing and selection risk and past performance means very little and has no predictive value. What currencies do you pick?

Let's say you liked the Australian dollar - there's a lot to like about the Aussie buck since the country is rich in natural resources relative to its population and has a thriving export economy. You could invest in the CurrencyShares Australian Dollar Trust ETF, which is up 12 percent for three years through June 15. But its annualized standard deviation - a measure of volatility - is 16.5. In comparison, a broad-based U.S. bond fund like the iShares Barclays Aggregate Bond fund has an annualized standard deviation of 2.7 with a three-year return of 7.3 percent. Unless you want to concentrate risk in a single currency, if you want less volatility with your income, a plain-vanilla bond fund might be better.

2. Hedge or short.

If you have a large percentage of your holdings in a single currency, you can buy an ETF to blunt that risk. Are you extremely pessimistic about the euro? The ProShares Ultrashort Euro provides a return two times the negative performance of the daily currency movement. That means this inverse fund will gain twice as much in value if the currency declines against the dollar. This is the riskiest strategy. You could lose all of your principal if you don't know what you're doing.

3. Have currency baskets.

This is essentially a hedge against a single currency, using several currencies to offset the overall risk. The Merk Hard Currency fund, for example, invests is several denominations to protect against the depreciation of the U.S. dollar. You spread out your risk a little more than the single-currency plays, but you're still only investing in a handful of major currencies.

4. Invest in non-U.S. stock and bond funds.

Unless your portfolio manager hedges for currency fluctuations, when you invest in the securities or bonds of other countries, your portfolio will be subject to currency gains and losses. For most mainstream investors, global stock and bond funds are probably the best approach since they offer diversified portfolios that offer some income in the form of dividends or yield. You also have the potential for capital appreciation. Besides, you need to diversify out of your home-country securities to reduce country risk. Two worthy candidates include the PowerShares Emerging Markets Sovereign Debt Portfolio and the Vanguard Total World Stock ETF .

If you decide to invest in currency ETFs, keep in mind that they are not only highly volatile, but more expensive relative to diversified bond or stock funds. While you may think that you're investing in the next safe-haven currency, you may be losing money along the way timing your decision and paying for transactions and management expenses.

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