Currency Funds May Help Mitigate Interest and Credit Risk
With ongoing market turmoil, investors may want to reduce their exposure to interest and credit risk in their international fixed income investments. One way to accomplish this may be to invest in international fixed income funds that have a commitment to the short end of the yield curve and to high credit quality securities.
Currency funds may be considered special cases of international bond funds, as many typically invest in international fixed income securities of short duration to gain currency exposure. As such, currency funds tend to focus on currency risk while seeking to mitigate interest and credit risk. Therefore, such currency funds may be worth considering as a tool to actively address interest and credit risk in a diversified portfolio.
International Fixed Income: Duration Matters
Reducing the duration of international fixed income investments may significantly reduce a portfolio's risk profile. The following chart illustrates the trade-off between risk and return when an investor moves further out on the yield curve, increasing duration (interest rate) risk. We depict the risk-return profiles over a 10-year period for international fixed income investments with maturities of one to three years as well as select international securities with maturities between five and seven years, in the respective local currencies.
On a risk-adjusted basis, our analysis found that investments in shorter duration international fixed income securities generally produced improved Sharpe ratios.¹ Increases in duration tended to exacerbate the risk profile with proportionally smaller increases in return. We found that during the 10-year period ending December 31, 2011, 86% of the international security groups Merk Investments analyzed had higher Sharpe ratios for maturities between one and three years relative to those with maturities between five and seven years.
For example, an investment in a basket of German Government securities with maturities between one and three years produced a Sharpe ratio of 1.37. In contrast, a corresponding basket of securities with maturities between five and seven years would have generated a Sharpe ratio of 1.05.
Currencies May Provide Enhanced Risk-Adjusted Returns
In practice, an investor participating in the international fixed income market is likely to invest in a basket of international securities of varying maturities and credit ratings. Such a managed basket is likely to leave the investor exposed to a broad range of credit and duration risks. Ultimately, these risks may have a significant impact on the overall performance of international fixed income investments.
Moreover, if managing the underlying currency exposures is not the primary focus or expertise of the particular international fixed income manager, sporadic currency allocation changes may detract from overall fund performance.
Currency managers specialize in the currency market. Currency managers typically aim to minimize the credit and interest risk by selecting securities of short duration and high credit quality, while focusing on generating enhanced returns through superior currency allocations. As a result, an investment in a professionally managed currency fund may offer attractive returns, and improved risk-adjusted performance, relative to other international fixed income investments.
The chart below outlines the risk-return profile of various international investments over the five year period ended December 31, 2011. Importantly, the risk-return profiles take currency risk into account; returns are calculated by converting the value of international investments into U.S. dollars at prevailing exchange rates. The Merk Hard Currency Fund is used as a proxy for the currency asset class, while we utilize a Bloomberg aggregate index of international Fixed Income Fund investments as a proxy for international fixed income. The S&P 500 index is also depicted for comparison purposes.
The Merk Hard Currency Fund may have generated higher levels of volatility than the international fixed income index due to its currency allocations; historically, the Fund has invested in more volatile commodity currencies, like the Australian dollar and the New Zealand dollar, as well as gold. While more volatile, these currencies have produced attractive return series over the time period analyzed. Indeed, on a risk-adjusted basis, the professionally managed currency fund performs particularly well, handsomely outperforming both international fixed income and U.S. equities, as measured by the Sharpe ratio, over a five year period: ², ³
Incorporating Currencies Into a Portfolio
We believe a currency allocation may be appropriate for investors seeking international fixed income exposure, but who are particularly worried about the credit and duration risk inherent in many international fixed income investments. As indicated above, this may be a valid concern. Indeed, according to a recent survey of investment professionals, 34% of respondents considered currencies to be a part of their short-term international bond allocation or an international cash allocation.4 A further 52% of respondents considered currencies to fall within their alternative assets allocation.
The same survey found that 50% of investment professionals who invest in currencies allocate between 4% and 6% of their portfolio to the currency asset class, with a further 34% of respondents indicating an allocation of up to 3% to currencies.
In addition to providing a potentially attractive alternative to help address interest rate risk and credit risk concerns, an allocation to currencies may enhance a portfolio's risk-adjusted returns. Currencies have historically exhibited lower levels of volatility and low correlation to traditional asset classes, thus a currency investment may provide valuable portfolio diversification benefits.
¹ Sharpe Ratio: Sharpe Ratio measures return per unit of risk.
² Benchmark used for International Fixed Income = Bloomberg active index (BAIF) representing a composite of open-end, internationaln debt funds domiciled in the U.S. (Bloomberg ticker: BBOEIDUS)
³ S&P 500 Total Return Index (SPXT)
⁴ Source: Merk Investments RIA Surveys, 2011 and 2012. Aggregate responses of 82 RIA's and intermediaries, ranging from under 50 million to over 4 billion in assets under management
Performance data represents past performance and is no guarantee of future results. Current performance may be lower or higher than the performance data quoted. Investment return and principal value will fluctuate so that an investor's shares, when redeemed, may be worth more or less than original cost. Please visit www.merkfunds.com for most recent month end performance. Through 12/31/2011, the Merk Hard Currency Fund Investor Shares had a 1-year return of -0.77%, a 3-year return of +5.73%, a 5-year return of +5.29% and a return of +5.31% since inception on 5/10/2005. All performance figures greater than 1-year are annualized unless otherwise specified. The Fund's Investor Shares expense ratio is 1.30%.