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By Nadia Papagiannis

At the inaugural Morningstar ETF Invest Conference last week, Axel Merk, founder of Merk Investments, presented some solid arguments as to why typical investors should include currencies in their portfolio. First, positive risk-adjusted returns are on the horizon. Second, currency strategies can provide low correlations to traditional stock and bond investments. And third, investors seeking refuge in bond funds may suffer a rude awakening with a rise in interest rates or a potential bubble burst. This all sounds convincing, but what exactly are the options for currency investing, and have they performed as advertised?

According to the Bank for International Settlements, average daily turnover in the global foreign exchange markets is almost $4 trillion, not including exchange-traded currency futures contract volume. The amazing liquidity in this asset class lends itself well to investment vehicles that allow for frequent redemptions, such as mutual funds and exchange-traded funds. There are 15 distinct mutual funds in Morningstar's currency category, and 31 ETFs (including 10 exchange-traded notes)--11 with more than $100 million in assets. Most of the currency mutual funds are actively managed (10 of 15), whereas all but two ETFs follow passive index-tracking strategies, requiring an investor to have some sort of investment thesis. Of the passive strategies, most ETFs are short the U.S. dollar and long a foreign currency or a basket of currencies. Some passive funds are leveraged up to two times. In the active space, the available ETFs follow the "carry trade" ( PowerShares DB G10 Currency Harvest (NYSEARCA:DBV), taking long positions in high-yielding currencies and short positions in low-yielding currencies. Actively managed mutual funds also incorporate carry strategies, but may combine it with other alpha-seeking strategies, such as valuation (purchasing power parity, for example) or momentum (long-appreciating and short-depreciating currencies). The mutual funds with the longest track records, however, aim to profit from a falling U.S. dollar.

Evaluating currency funds is tricky, not only because they follow different strategies, but also because most are relatively new. Only one mutual fund or ETF existed prior to 2005, Franklin Templeton Hard Currency (ICPHX), and only a handful have five-year track records. Nevertheless, one can still get a good idea of how these currency funds might work in the portfolio with a few examples.

To compare the performance of any investment, one should look at a measure of risk-adjusted return over time. Because most funds in the category lack a Morningstar rating, the Sharpe or Sortino Ratios make good substitutes. The Sortino ratio is similar to the Sharpe Ratio, but only looks at downside risk. Using weekly returns (versus monthly) makes the statistic more valid. Over the last 52, 156, and 260 weeks ending Aug. 28, 2010, only two of six funds generated positive risk-adjusted returns (Merk Hard Currency (MERKX) and Franklin Templeton Hard Currency). Over the last one and three years, 11 of 26 funds managed positive risk-return profiles, including long Yen, Swiss Franc, Australian Dollar, and Canadian Dollar ETFs. However, none of these funds provided better risk-adjusted returns than the BarCap US Aggregate Bond Index, thanks to the spectacular performance of U.S. Treasuries, especially in recent periods.

To see if a fund is a good diversifier, one can also test how it performs under pressure. Between April and December 2008, when both the stock and bond markets tanked, the best-performing currency strategies were alpha-seeking, absolute-return strategies (such as the RiverSource Absolute Return Currency and Income (RARAX) and Invesco FX Alpha Strategy (FXAAX), long Asian-currency (Yen and Renminbi) ETFs, and long U.S. dollar funds. Every fund in the category lost money over this time frame, although a few lost less than both stocks and bonds.

The best measure of diversification potential is correlation, although correlations can change over time. The aforementioned Franklin Templeton fund, for example, which takes a short U.S. dollar position against an actively managed basket of currencies (using short-dated bonds), exhibits a wide-ranging rolling 60-month correlation to the S&P 500 since its 1989 inception, from negative 0.16 to positive 0.46, with higher correlations in recent years. Its correlation with the BarCap US Aggregate Bond Index has also varied, from 0.00 to 0.40. Since 2005, this currency fund has provided similar correlations to both stocks and bond as other actively managed short U.S. dollar funds (the Merk Hard Currency, for example) as well as passively managed funds with similar strategies (Profunds Falling US Dollar (FDPIX)). So it's likely that a short U.S. dollar basket investment strategy will provide low correlation with traditional stocks and bonds over the long term, but the correlation may vary widely from one period to the next. In the late 2008 flight to liquidity, for example, a short U.S. dollar strategy failed to provide diversification, as investors flocked to the U.S. dollar as a safe haven. Similarly, actively managed currency strategies such as the carry trade, a favorite of hedge funds, blew up as hedge funds needing liquidity closed out of these highly liquid positions en masse.

So it seems that some currency strategies might be able to provide a positive risk-adjusted return over time, but not better than U.S. Treasuries, and in periods of stress or flights to liquidity, some of these strategies might fail to deliver, although most preserved capital better than stocks or non-government bonds. Why then, shouldn't one simply diversify with U.S. Treasuries? The arguments against this are very compelling, and Axel Merk clearly spelled them out. First, the extremely low real interest rates of late are pushing investors out further on the yield curve in search of higher yield. But when interest rates eventually rise, these long-dated bonds will suffer most. Second, inflation may not be an immediate concern, but as the U.S. continues to stimulate various parts of the economy, it is sure to appear. And last, but by no means least, the U.S. may be in for a bond-bubble burst, especially in U.S. Treasuries, as evidenced by massive inflows. Merk is not the only pundit predicting a collapse in this market. Jeremy Siegel, a Wharton School of Business professor, and Jeremy Schwartz of WisdomTree also warn of this happening.

As such, a currency investment makes sense as part of a diversified portfolio. Before delving into these strategies, though, investors should take the time to look under the hood, as not all currency strategies are equal. Positive risk-adjusted return and low correlation are some good screens. As with any other investment, one should also examine the nuts and bolts of each currency fund structure, as currency exposure can be achieved through cash currencies, futures (exchange-traded), forwards (over-the-counter), swaps (in the case of ETNs), or bonds, which may impose additional risks to investors, such as counter-party credit risk, interest-rate risk, or tax concerns. Expenses can also vary widely, as the more actively currency-managed strategies are dearer. But results are net of expenses, and the diversification benefits of some currency funds may be well worth the price.

Disclosure: Morningstar licenses its indexes to certain ETF and ETN providers, including Barclays Global Investors (BGI), First Trust, and ELEMENTS, for use in exchange-traded funds and notes. These ETFs and ETNs are not sponsored, issued, or sold by Morningstar. Morningstar does not make any representation regarding the advisability of investing in ETFs or ETNs that are based on Morningstar indexes. Tim handles their stock strategist posts (separate feed) if you need help formatting or have other Morningstar-related questions.

Source: Are Currencies Really a Good Investment?