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Beware the pitfalls of currency investments

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For the global investor, currencies may present an attractive option as a stand-alone asset because of potential high returns, but there are pitfalls.

Chief among those is a need to avoid excessive foreign-country redundancies in investors’ portfolios by buying equity and currency assets from the same place. Advisors should guard against assuming that a nation’s currency value will move in the same direction as its equity assets but, at the same time, avoid overly complex hedges for unsophisticated clients.

The appeal of investing in foreign currencies as stand-alone assets is portfolio diversification and protection should the U.S. dollar fall.

But foreign currencies also act as a hedge against some of the risk of foreign-equity investments, says Christopher Gannatti, associate director at New York-based WisdomTree Investments, which offers exchange-traded funds with foreign-currency and foreign-equity assets.

He thinks that investors may choose to buy equity in a foreign country but will face some risks by doing so, which they could avoid with foreign-currency hedging strategies.

“The currencies in a country may be weakening, but some of the companies in the same country may be doing well as a result of that,” Gannatti says.

If its nation’s currency falls, a foreign company may as a result sell more imports because its products will be cheaper for many overseas buyers. There the foreign company will become more profitable and deliver greater returns to investors despite the weakening of its currency.

The template for such a scenario was the Japanese market last year, when the yen dropped but the equity markets improved.

WisdomTree tailors some of its ETFs to address the inverse relationship that may occur between a currency and foreign company’s import sales. It adds hedges by investing in one country’s equity but in the same fund in future contracts betting against that same foreign country’s currency rise.

Not everyone, however, subscribes completely to this proposition.

“There are different ways of doing these things,” says Kathleen Ann Nemetz, a financial planner with McClurg Capital of San Francisco. With asset allocation and portfolio diversity, most non-institutional investors can avoid too much risk in one country’s currency and equity without attempting overly sophisticated hedging strategies better left to those who have 24/7 coverage of market fluctuations, she says.

Miriam Rozen, a Financial Planning contributing writer, is a staff reporter at Texas Lawyer in Dallas.

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