How currency reduces portfolio risk as a diversifier
Oil-heavy Norwegian krone, industry-based Swiss franc and US dollar each has its own behaviour
From the Hungarian forint to the Chilean peso, currencies can be a valuable partner in managing investments.
Currencies offer a source of diversification. The oil-heavy Norwegian krone, for instance, behaves differently to the industry-based Swiss franc, and they each behave differently to the US dollar.
When things are tough in energy-based Norway things could be fine in pharmaceutical-exporting Switzerland and your “drugs and oil” portfolio will earn in dollars as the global default currency.
As with other asset classes, combining noncorrelated assets into a portfolio creates diversification, which means you can achieve the same investment outcome with lower volatility. In this way, currency, as a diversifier, reduces portfolio risk.
Currencies can also be a source of return in at least two ways:
- Buying a currency when it is attractively priced and selling when it appreciates, for example the inexpensive and appealing Canadian dollar, or Loonie.
- Owning a currency that is structurally sturdy and likely to strengthen steadily for long periods. You can buy it and hold it forever (Warren Buffett’s favourite holding period).
The Swiss franc or Swissie, is a good example, given Switzerland’s geopolitical advantages and its strong economic and financial systems. Thus, adding such currencies to a portfolio could be a good way to add to investment returns while lowering risk.
Currencies can also be a source of risk, with dangerous implications for returns. Rushing from one currency into another that is strong in a moment of weakness often produces painful results, certainly in the near term. Selling the rand at R19 to buy the greenback in April produced a three-month loss of 10% — and slightly more if we consider dollar balances earned 0% interest vs the opportunity cost of interest earnings on rand investments.
In five or 10 years, this rand recovery might be seen as a mere blip if the rand were to reach R30 or R50 to the dollar should the rand buckle under the weight of SA’s crumpling economy. Or it could be that, in fashion with its multidecade habit, the rand will recover 30%, 40% or 50%, as after the Rubicon speech, global financial crisis and Nenegate.
The rand could also collapse in a Venezuelan heap in which that currency has undergone a cumulative devaluation of 100-million to one since 2008 — an investment of $1m in 2008 would be worth 1c in 2020. Zimbabweans know the devastation of currency collapse (2008), as do Germans (1923) and Brazilians (1985).
If nothing else, this emphasises that currencies can be volatile. If managed well, volatility can be a blessing; if not, volatility is a source of risk or even destruction. However, simply buying other currencies is not good diversification — rather, acquiring other currencies at good valuations makes for good diversification.
This raises at least two questions:
- In a world rocked by Covid-19 and shrouded in uncertainty, which currencies possess structural strength?
- Based on this assessment, on what valuations are they now trading?
We assess currency stature by 12 measures of strength and stability to score all major currencies and many smaller ones across three pillars: external strength and international dependency; effectiveness of economic management and country vulnerability; and ability of the system to absorb currency shocks.
The first chart shows the results for key and interesting currencies. Lower scores mean stronger currency structures. Unsurprisingly, the Swissie is strong and investible, with evidently low risk; the Sudanese pound and Cuban peso are closer to a world of “uncertainty and unknowability” than to risk. The latter are not the places in which to put investment capital, no matter how compelling the “valuation”. The SA rand is in the company of the Vietnamese dong and Argentinian peso.
The second question is about fair value. Benjamin Graham’s comment, “In the short run the market is a voting machine but in the long run it is a weighing machine”, is seldom truer than in the case of currency, in which weight comes in the form of purchasing power parity. It is almost impossible to predict near-term currency moves but its fair value can be weighed with the robust tool of purchasing power parity (effectively an economywide “Big Mac index”).
The second chart shows the currency structure score plotted against purchasing power parity relative to the dollar. A few things leap out. In a world awash with dollars almost every currency is attractive in valuation compared with the dollar. Only two currencies are “expensive”: the Swiss franc and Swedish krona. If you are investing, the sweet spot sits in the world of structurally strong and attractively priced currencies: South Korea, Singapore, Israel and Japan stand out. In which case your currency could be buying Samsung, Singtel, Shufersal or Softbank.
Investing sits on two core pillars: buying good assets, at good prices. Adding a currency lens allows enhanced investment performance via even greater quality at even better prices. As Sid Cottle said: “Investment is the discipline of relative selection.”
• Saville is CEO and Ferreira investment analyst at Cannon Asset Managers.
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