Currency Risk: Mitigation of Portfolio Risks in Times of Crisis

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 |  Includes: ABX, EWY, FXA, FXE, GDX, GDXJ, GLD, JNJ, NEM, PG, SLV, SPY
by: Bob Johnson

Turning Points

The market reacted sharply to the to the US National Debt crisis. From July 21 to August 3, the Dow fell 828 points. After bad economic news, it was down over 1000 additional points in five days. Since then it has been volatile on heavy volume. Investors are anxious and afraid as they react to the crisis.

Crises take many forms and the next big shock might not be an economic one, though it will no doubt affect the markets. Somewhere in the world a government topples, a war begins, a drought precipitates a famine, terrorists attack, a volcano erupts, a nuclear plant melts down or a deadly epidemic begins.
Crsis is a word used from the time of Hypocrates to refer to the "turning point in a disease". A more general definition is that it is a stage in a sequence of events at which the trend of all future events is determined; a turning point.

You probably heard that the literal meaning of the Chinese word crisis = danger + opportunity. Unfortunately, that’s a western myth based on an optomistic misunderstanding of Chinese symbols. Like most Mandarin words, the word for crisis, wēijī, consists of two syllables that are written with separate characters, wēi (危) and jī (機). However, ji does not mean opportunity. Rather, ji means crucial moment. Correctly understood weiji means the crucial moment of danger, or, imminent danger as a scholar explains. Few find it to be a time of opportunity.

Thesis

In times of crisis, the majority of investors do not make their best decisions. Crisis spreads like a wildfire, and like a wildfire, it engulfs everything in its path. Sentient beings run wildly, even blindly, from its path. It is difficult to think long term while the crisis escalates. When the crucial moment passes, after the panic wanes, it is a good time to assess your situation and make future plans. It is better to be prepared for crisis than to react to it; to fireproof your portfolio so that a crisis has a minimal effect. This article will help you do that.

My recently published a Seeking Alpha article entitled “Portfolio Basics for Periods of Crisis” is an overview of strategies for investing in times of crisis. This article goes beyond that overview and examines the details, the tactics, to employ in one area: the cash dollars you hold and the dollars your other assets are held in. The value of the dollar is at risk for many reasons and its value is subject to decline. Ways to mitigate this currency risk are discussed.

Cash

It is necessary to maintain a cash position as one of your investment assets. First, cash in the form of US dollars is the medium of exchange you use when buying or selling other assets. One cannot be an active investor without cash. You will need cash to implement any changes to your portfolio, to diversify it with additional asset classes or to diversify within asset classes. The adage is to buy low and sell high; this requires cash to make purchases. Many investors have a usual amount they use to make a typical new investment. Depending on your investment resources, this could be $1,000, $10,000 or $100,000. Whatever it is, you should keep two or three times that amount available to make anticipated buys, including those triggered by active buy-limit orders.

Cash is the medium you gain for the proceeds of opportune sales. In most cases, it is how you receive your dividends and interest. Cash reduces the volatility of a portfolio. Regardless of currency fluctuations, dollar weakness against other currencies and a lowered S&P US debt rating of AA, the US dollar remains a coveted currency worldwide. However, in the past year its value has declined against many other currencies including the Swiss franc and the Canadian and Australian dollars.

Cash equivalents are very similar cash and are subject to the same risks. These assets are readily convertible into cash and include money market holdings, Treasury bills, marketable securities and commercial paper. Cash equivalents are of short maturities; they mature within 90 days. Cash equivalents have no significant risk of change in value other than that of the currency they are held in.

For convenience in executing transactions, many people hold what they expect they will need in working cash in a money market account with their broker. An increasingly popular alternative for additional money is Treasury bills, a safe haven in a time of crisis. Treasury obligations are safer than money in the bank or held by a brokerage as there are no limitations to the amount guaranteed. The interest yield is about as low as it could be, 0.01%, for a 1 month maturity.

Non-US Currencies

Holding strong non-US currencies is a way of diversifying to diminish currency risk. Currency has traditionally exhibited low correlations to other asset classes. Largely, this is because currency valuations are driven by factors different from those that drive the performance of other asset classes. So, how does one invest in foreign currency?

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FOREX

FOReign EXchange is a $4 Trillion daily market involving currency trading and speculation. The foreign exchange market, according to The Economist, “is a worldwide decentralized financial market for trading currencies. Financial centers around the world function as anchors of trading between a wide range of different types of buyers and sellers. The foreign exchange market determines the relative values of different currencies. The primary purpose of the foreign exchange is to assist international trade and investment by allowing businesses to convert one currency to another currency. For example, it permits a US business to import British goods and pay Pound Sterling, even though the business' income is in US dollars.” It also supports direct speculation in the value of currencies, and the carry trade, speculation on the change in interest rates in two currencies.

Many exchanges in the U.S., particularly the Chicago Mercantile Exchange (CME), offer currency futures contracts to mitigate exchange rate risks. Hedging involves buying and selling futures currency contracts, and many other stragies. A company, expecting payment in another currency six months from now, when a job is completed, could sell a futures contract for that amount of the currency. If, in the interim six months, the value of that currency declined, they will be able to buy back the futures contract at a lower price, offsetting the decline in value of the payment they receive.

Volume on the CME hit record levels on Tuesday August 9, 2011 with 25.7m contracts traded across all asset classes, with records set in two asset classes, the Australian dollar and gold. ”With all this volatility and uncertainty, people might be nervous about making big, long-term bets on stocks. The leverage built into derivatives allows investors from smaller, shorter-term trades.” Said Justin Schack, who is the managing director at Rosenblatt Securities.

The Wall Street Journal reports that foreign exchange was CME's fastest-growing business in 2010 and appears to represent its best chance to win business from overseas traders. So far, the CME is having some success. Last year, daily trading in CME currency futures for the first time surpassed the volume in its agricultural commodities business. Having made an ambitious but less than successful bid to enter many facets of the currencies market in 2008, CME is sticking closer to its home base: the futures market. CME is promoting its currency contracts to customers that frequent its markets in crude oil, metals and stock-index futures in a bid to become the single largest point of trade for currencies.

In currency markets worldwide, the contracts traded are Spot, Forward, Swap, Future and Options. The top-tier interbank market accounts for 53% of all transactions. The leading traders include Deutsche Bank (NYSE:DB), Barclay Capital (NYSE:BCS), JP Morgan (NYSE:JPM), Citi (NYSE:C) and Goldman Sachs (NYSE:GS). The most frequently traded currencies are the US dollar, euro, Japanese yen and the British pound. FOREX trading is highly sophisticated and very speculative. Participants include hedge funds; George Soros made a good part of his fortune in Foreign Exchange. For the most part, it is not a place for individual investors. However, there are firms that specialize in the retail market.

Direct Investment in Currency, Mutual Funds

Unlevered currency investments are less volatile than other asset classes, such as equities and fixed income investments. Single currency risks are reduced by these investments. The largest and one of the oldest is the Franklin Templeton Hard Currency Fund (ICPHX) with assets of about $600M. The Fund invests primarily in high quality, short-term money market instruments (and forward currency contracts) denominated in currencies of foreign countries and markets that historically have experienced stability and low inflation rates. When the dollar falls, the fund gains. Another fund with similar objectives is the Merk Hard Currency Fund (MERKX) which seeks to profit from a rise in foreign hard currencies versus the U.S. dollar. Its holdings by country are below. Merk, as well as many others, considers that gold is a currency.

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The above is a great chart to show the abatement of risk that occurs when you add a currency fund to your portfolio. The blue line, The Merk HardCurrency Fund (MERKX) shows very little correlation to the S&P 500 (SPY). This is particularly true when the stock market takes its sharp downturn at the end of July. While this fund is designed to hedge against currency risk, and it does, it is so unconnected to the stock market it adds stability to your entire portfolio.

The nature of the holdings in the hard currency funds is usually in the form of money market funds and short-term notes. The average duration of Merk’s holdings is 0.4 years. Unlike a bond fund, a hard currency fund has very little, if any, interest rate risk. Below are some additional currency mutual funds. Most of these funds are available in several classes such as A, C, and I. The retail version, Class A, is shown.

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Direct Investment in Currency, ETFs

The hard currency ETFs also seek to profit from the strength of foreign currencies compared to a weaker dollar. The objectives are the same as the currency mutual funds. The structure is slightly different as ETFs are index funds. For that reason, each of the ETFs is an index fund of the currency of a single country. If you want to put together a blend of non-inflationary stable currencies, you can purchase shares in several funds.

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Foreign-Currency-Linked Bank CDs

Everbank, an online bank in Jacksonville, Fla., offers CDs denominated in about 15 foreign currencies. The minimum investment is $10,000 and terms range from three to 12 months.

"Say you want to buy euros. You open an account with Everbank and give us your $10,000," says Chuck Butler, president of Everbank World Markets. "We take your dollars and convert them to euros. When the term ends, we take the whole lot of euros -- principal and accrued interest -- and covert them back into dollars at a rate that is within 1% of the spot rate." That 1% (or less) represents Everbank's fee. You pay it each time you buy or sell a CD. If you bought currencies yourself, you would pay considerably more. Everbank's CD interest rates depend on the country and the term, but range from zero for Japanese yen CDs to 11.5 percent for CDs denominated in the highly volatile Icelandic krona. Euro CDs are paying 2 to 2.5 percent.

Offshore Banking

An offshore bank is located outside the country of residence of the depositor, typically in a low tax jurisdiction that provides legal and financial advantages. These advantages typically include privacy, low or no taxation and protection from political instability. While the term originates from banks being on islands in the English Channel, "offshore" from the UK, the term now refers to a type bank regardless of location, including Swiss Banks. Offshore banking has often been associated with the underground economy and organized crime, via tax evasion and money laundering.

Although offshore banks may decide not to report income to tax authorities, and have no legal obligation to do so as they are protected by bank secrecy laws, this does not make the non-declaration of the income by the tax-payer legal or the evasion of the tax on that income legal.

Offshore banking is an important part of the international financial system. Experts believe that as much as half the world's capital flows through offshore centers. Offshore banks hold one third of the wealth of the world's “high net-worth individuals”. Swiss banks are big players in this business and have a well-deserved reputation for secrecy.

Offshore banks are not only obscure banks with post office boxes for addresses, but also large, reputable international banks. HSBC Bank (HBC) offers offshore banking based in Jersey, Channel Islands. They provide offshore banking and investment services for customers in over 200 countries and territories. They offer international access to multi-currency accounts and investments. Accounts may be in sterling, US dollars, euro and 14 other currencies.

Also offered are Foreign Exchange Services. These include access to Foreign Exchange Specialists, and a full range of foreign exchange solutions and transfers in 20 currencies. Spot transactions make a foreign exchange transfer at the current exchange rate. Fixed forward transactions let you fix the exchange rate, which will remain constant regardless of world currency fluctuations, for a foreign exchange transfer you want to make on a set date in the future. Limit orders are available which convert your money when the exchange rate reaches a certain level.

Foreign Bond Funds, Mutual Funds

A bond or bond fund is something you are probably much more familiar with than you are a direct investment in currency. A bond is an IOU. If you buy a 20 Year US Treasury Bond then you have loaned the government $1,000 for a ten-year period. In the meantime, twice a year you will get an interest payment for the six-month period at the rate agreed upon as part of the issuance of the bond, say 5% a year. The bond is subject to interest rate risk. It will be redeemable at face value at maturity. If you sell before then, you will get less if interest rates are up, more if they are down. The shorter the duration of the bond the less it will fluctuate as interest rates change.

The Templeton Global Bond Fund (TPINX) holds over $46B in short - intermediate term debt of sovereign nations outside the US. The average maturity is 4.3 years and the average duration is 2.4 years. Holding are: Non-Japan Asia 42%, Europe 29%, non-US Americas 12%, US 4%, Supranational 3% and Cash 10%.

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The advantage of holding the bond, or bond fund, is that while a hard asset fund invests in very short term instruments, like money market funds, bonds are for a longer term and pay a higher interest rate. Some advisors say that if a client has an international bond fund, it is unnecessary for them to get into other kinds of dollar hedges. I am sure there are exceptions to this.

International Equities, ETFs

Another way to diminish currency risk is to invest in companies based in countries with strong and stable currencies.

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Looking at country funds for the last 3 months, it is apparent that most of the world is in sharp decline. Indonesia and Maylaysia are less so compared to the US.

US Based Multinational Corporations

International Equities

The primary reason to invest in US Based Multinational Corporations is to profit from their ownership, which includes access to global markets. Procter and Gamble’s (NYSE:PG) products reach 4.5 Billion of the 7 Billion people on the planet. Johnson and Johnson (NYSE:JNJ), Abbott Labs (NYSE:ABT), and McDonalds (NYSE:MCD) all get about half of their revenue outside of the US. Investing in US Corporations that have significant international revenue streams also reduces currency risk. Foreign stocks offer a more focused approach to international exposure than buying domestic multinationals or ETFs. In addition to exposure to specific countries and their currencies, there is the opportunity to share in the ownership of excellent firms, often with dividends larger than those of typical US stocks.

We will examine these firms in detail in a future article when we discuss the asset classes US Equities and International Equities.

Precious Metals

According to some, gold is the de facto international currency. Its phenomenal price appreciation in these times of crises gives good evidence of that. Investors and speculators worldwide seek gold. It is certainly in a class of its own. Silver and platinum are popular noble metals too. Like the good alternate investment that precious metals are, their value does not correlate closely with other assets.

There are a number of ways to purchase gold and silver.

Physical Gold, bullion

I Googled the phrase “buy gold” and on the first page the usual hits statistic popped up. It said, “about 2,000,000 results in .25 seconds.” You can buy gold, have it shipped by the USPS certified and insured mail, and take delivery at your home. Monex is one of many dealers who can assist you. They say, “Gold bullion is real, honest money...and, many say, the best form of money the world has ever known. It is a store of value and a safe haven in times of crisis. Gold is rare, durable and does not wear out in the manner of lesser metals (or paper!) when passed from hand to hand.

A small amount, easily carried, can purchase a significant amount of goods and services. It is universally accepted, and can be easily bought and sold around the world.” For a few tips on buying gold, you can check out this site, which has some good links some good links, Goldprice, or this ehow site, which assures you that all you need to buy gold is the internet and money. In addition, dealers in bullion are usually also deal in modern coins.

Physical Gold, Coins

Conversely, dealers in coins also sell bullion. A dealer I have visited, their business is primarily done on the internet, is Gainesville Coin. They offer a wide selection of modern gold and silver coins including the American Eagle, Canadian Maple Leaf, Krugerrand, Australian Kangaroo and even the Fiji Taku. Called bullion coins, their value is based not on their face value, not on their collectible value, but on the equivalent value of the same weight in bullion. Sometimes there is a small premium for the coin, but a 1 oz. bullion coin is valued at its weight in the gold or silver from which it is minted.

The South African Gold Krugerrand dominates the bullion coin market and is the most widely held and actively traded bullion coin. Not only was the South African Krugerrand the first bullion gold coin to be marketed as a vehicle for private ownership during the 1970s, it was also the first gold bullion coin to be minted in exactly 1 oz fine gold increments. Developed by the South African Chamber of Mines on behalf of the South African gold mining industry and officially authorized by the South African Reserve Bank, the Krugerrand continues to be on of the most widely produced and recognized gold coin both internationally and domestically, with nearly 46 million ounces produced and distributed worldwide.

Physical Gold and Silver Held By ETFs

The SPDR Gold Trust ETF (GLD), according to Yahoo Finance, seeks to replicate the performance, net of expenses, of the price of gold bullion. The trust holds gold, and is expected to issue baskets in exchange for deposits of gold, and to distribute gold in connection with redemption of baskets. The gold held by the trust will only be sold on an as-needed basis to pay trust expenses, in the event the trust terminates and liquidates its assets, or as otherwise required by law or regulation. It has $56B in assets. Expenses are 0.40%.

The iShares Silver Trust ETF (NYSEARCA:SLV), seeks to reflect the price of silver owned by the trust, less the trust's expenses and liabilities. The fund is intended to constitute a simple and cost-effective means of making an investment similar to an investment in silver. Although the fund is not the exact equivalent of an investment in silver, they provide investors with an alternative that allows a level of participation in the silver market through the securities market. YTD returns have been 28.7%, 12 month 121.0%, 3 year 30.4%. It has $13B in assets. Expenses are 0.50%.

Gold Miners

The price of gold has skyrocketed. However, the stock of gold miners is selling at the lowest multiples in years. Of all the ways to take a position in precious metals, “large mining stocks, small miners, gold, silver and platinum... the big miners look the cheapest, in relative terms” says Brett Arends in Smart Money. Barrick Mining (NYSE:ABX), the world’s largest gold miner, is trading at just 10 times forward earnings, Newmont Mining (NEM) has a P/E of 13. Their prices are also at historic lows in relation to the price of gold. Does that mean that their stock prices will go up?

Miners are very volatile companies, Large, international multi-mineral miners have an average beta of around 1.40. The larger gold miners are less volatile with a beta about half that, at 0.70.

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Plotting two of the largest gold miners (ABX purple, NEM orange) and two of the largest other miners (BHP Billiton Limited (BHP) red, VALE green) this becomes clear. When the stock market started falling sharply, the large multi-mineral miners declined more than the S&P 500, an average of -15%, while the two gold miners increased an average of about 3%. The gold miners are playing their role well as alternative assets showing a negative correlation to other miners and to the S&P 500 in this time of crisis .

Gold Miners, Companies Ranked by Production

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Gold Miners, ETF

Market Vectors Gold Miners ETF (GDX) seeks to replicate as closely as possible, before fees and expenses, the price and yield performance of the NYSE Arca Gold Miners Index. The fund generally normally invests at least 80% of its total assets in common stocks and American depositary receipts of companies involved in the gold mining industry. It is non-diversified. This fund has a market cap of $6B, a P/E of 15, and a yield of 0.73%. Its performance YTD is -11.2, 12 month 5.8%, and three year 4.3%. The expense ratio is 0.53%.
The Market Vectors Junior Gold Miners ETF (NYSEARCA:GDXJ) seeks to replicate, net of expenses, the Market Vectors Junior Gold Miners index. The fund normally invests at least 80% of total assets in securities that comprise the index. The index tracks the overall performance of foreign and domestic publicly traded companies of small- and medium-capitalization that are involved primarily in the mining for gold and/or silver. The fund is non-diversified. The fund has a market cap of 2.3B, a P/E of 14, and a yield of 8.1%. Its performance YTD is -9.63 and 12 month is 45.25. The expense ratio is 0.54.

Silver Miners

Here is a recent list from the Silver Institute which shows the Top 20 producers.

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The silver miners are not such large and focused companies as the gold miners. Often, in the course of mining another metal, such as copper, a small amount of silver is mined as a byproduct. Accounting wise, miners often look at the sale of this byproduct as a reduction in mining costs rather than part of the mining revenue. Small scale silver mining, on a stand-alone basis, can be profitable. Seeking Alpha contributor, the Prudent Investor, provides about 200 names and links to many of them in his article 2010 List of Silver Mining Stocks and Companies.

Silver miners do not have the same investment characteristics as gold miners. Fresnillo Mining is the world's largest primary silver producer and its Market Cap is 12.4B. Pam American Silver (NASDAQ:PAAS) has a Market Cap of 3.1B; Coure d'Alene Mining as a Market Cap of 2.3. They are much more volatile than the gold miners and much less profitable. I included silver here as it is always mentioned in the same breath as gold. Silver miners are not on my watch list at this time.

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Conclusion

I believe we have shown the currency risks which are inherent in holding cash, specifically as it pertains to the dollar. These risks extend to all on your portfolio which is held in dollar based investments, such as US stocks and bonds. These risks may be mitigated by a number of tactics which are presented above. One or more of them may be appropriate for your individual situation and lend stability and safety to your portfolio making it less volatile in times of crisis.

May you find joy in your prosperity and sleep well at night.

Disclaimer: No recommendation is made for any of the securities above. Rather, they are presented to to increase your awareness of possibilities. Enjoy your exploration of alternatives and do your own due diligence before making any purchases.

Disclosure: I am long SLV, EWY, ABT, MCD, PG, JNJ.