Currencies As A Hedge

In the aftermath of the global credit crisis, it has been hard to find truly uncorrelated asset classes in the capital markets.  Uncorrelated investments are a way to protect against downside risk.  However, since many asset classes continue to move in the same direction simultaneously, it has become increasingly difficult to find those assets that exhibit such uncorrelated behavior.  The hard currency asset class may fill this void. The currency asset class has historically displayed low correlations to traditional asset classes, such as stocks, bonds, and commodities, and offers potential profit opportunities given its unique market structure.  Therefore, the addition of a currency compo­nent to a portfolio may deeply enhance the risk/return profile over time.

During the run-up to the credit crisis in 2008, asset classes became increasingly correlated, and that phenomenon has continued to this day.  Most asset classes generally moved up in tandem approaching the credit crisis; most asset classes moved down together as the credit crisis unfolded; and, broadly speaking, most asset classes have contin­ued to move in lock-step ever since. In order to truly diversify and hedge downside risk, it is important to add uncorrelated assets to a portfolio whenever possible.  It is within this framework of portfolio construction that the addition of the currency asset class may provide excellent potential.  Currency investments have historically exhibited very low correlation to many other asset classes.

The effect of many non-profit seeking participants in the currency market may enhance the uncorrelated attribute of the asset class.  For example, multi-national corporations might contract to buy or sell certain currencies for the primary reason of hedging against currency risk on future earnings or expenses in a certain country; governments and central banks are active in managing foreign currency reserves; even tourists are active currency market partici­pants – when tourists spend money on souvenirs, food or any travel related expense in a foreign currency they influence the price of that currency, even if they are unaware of it.  Such non-profit seekers can have substantial influence on currency price movements and valuations. The effect of these entities’ actions can cause currency prices to move in directions that are largely uncorrelated with most other asset classes.

Additionally, many currency investment strategies are aimed at profiting from trends that are completely unrelat­ed to other asset classes, and therefore also generate return series that are uncorrelated to other asset class returns.  An often overlooked attribute of the currency asset class is that when an investor purchases one currency, the investor is also, by implication, selling another currency, as currencies always trade in pairs. Therefore, the return generated from a currency pair is likely to differ from, and be uncorrelated to, returns of the broad stock market; which is turn adds an effective hedge to a portfolio.

Return vs. Yield

A year or so ago, I remember having a discussion with a former colleague about the performance on a certain mutual fund. As we were going over the numbers on the fund’s fact sheet, he finally asked me, “So what is the difference between annual return and yield?” Being that he had worked as an advisor for a major brokerage firm for many years, I initially thought he was kidding. But by the puzzled look on his face afterwards, I quickly realized that he truly had no idea. Without poking any fun, I explained it to him as simply as I could.

Since then, I have had other clients ask me the same question. As advisors, we use the two terms often and I think people sometimes believe that a portfolio’s annual return and a portfolio’s yield are both one and the same thing. This is not the case. Although each can be used to describe the overall performance of an investment or portfolio, the two terms differ in regards to specific time periods, (the past and the future).

“Return” expresses what an investor has actually earned on an investment in the past. This includes capital gain, interest, and dividends combined. “Yield”, on the other hand, just focuses on what the investment will pay the investor in the future. So, if you own a portfolio of stocks and bonds that is yielding 3%, but earned you 8%/year over the last decade, you know two things.

1. the total of all capital gains, interest, and dividends over the past decade averaged out to 8%.

2. if you continued to hold the portfolio unchanged for one year, you will earn 3% of interest and/or dividends of what the overall portfolio value is at that moment in time.

In looking backwards, the yield the portfolio generated in the past has already been calculated into the 8% return the investor has seen. But in looking forward, you can only calculate what the yield will be, (based on the current value of the portfolio and the amount of income the portfolio is expected to pay). We have no idea what the value of the holdings in the portfolio will be in the future. But we do know what those holdings will pay us if we continue to hold them. If we end up holding that same portfolio for another year and the price of the securities goes up another 10%, the return would end up being 13% on the year, (10% gain + 3% yield = 13%). Understanding this concept becomes important when looking at certain investments, (stocks, bonds, mutual funds, exchange–traded funds, etc). Knowing what a portfolio has earned in the past and knowing what the portfolio will yield in the future can certainly help investors make smarter, and more informed decisions.

The Sky is Falling...

As it has been said, what goes up must come down…this past week silver experienced a free fall as the precious metal dropped from almost $48.50 to roughly $34 in one week – a drop of over 30%.  The silver market witnessed “parabolic downside turbulence”.  This dynamic happens when a sharp rise in a short period for no reason other than investors falling over each other to buy; is followed by a swift and sharp sell off as investors fall over each other to sell.

Much of the sell-off in silver was attributed to tougher margin requirements for speculative traders. The Comex exchange had raised trading margins on silver contracts for the third time in two weeks.  Comex said this week that the minimum amount of cash that must be deposited when borrowing from brokers to trade silver futures will rise to $16,200 per contract at the close of business yesterday, from $14,513. A year ago, the margin was just $4,250. There was also news that one of the biggest silver bulls in the world, Eric Sprott of Sprott Asset Management, had started selling 35 million shares of Sprott Physical Silver Trust (PSLV), a silver-based ETF.

Back in the 1970’s the Hunt brothers of Texas tried to corner the market in silver. Back then, after futures rallied to a record $50.35 an ounce in January 1980, prices dropped 78 percent in four months and wasn’t until this past week that prices got even close to that level.

Overall, silver has gained more than 145% in the past year, and 20% in April alone.  Unlike gold, which is typically bought and held by large investors and central banks, silver is dominated by individual investors and hedge funds looking to capitalize on the hot play du jour.  It will be very interesting to see if silver follows the same path that it did after the peak in 1980.