Diversification - Currency Diversification

So what is currency diversification and should you add currencies into your Mix?

It is a portfolio diversification strategy in which securities are purchased in various foreign currency denominations for purposes of minimizing foreign exchange risk, increasing global exposure, and capitalizing on exchange rate disparities. The currency fluctuation and volatility has prompted many to study the need to diversity your asset class into various currencies denomination. 

The need of currency diversification has been accelerated by events happened in the past as well as what is happening now. 

Take a look at the 2008 financial crisis that hard hit many countries around the world when all sorts of assets fell in tandem, supposedly revealing that the benefits of diversification are ephemeral. A quick look at the core stock classes in 2008 shows that pain was evenly spread across every major category with U.S. stocks down 36.2 percent, foreign developed markets down 43.4 percent, emerging market stocks 52.9 percent, and even the nontraditional classes of REITS and commodities hit with declines of 37.6 percent and 31.9 percent respectively. And what is happening now is the phenomenon of globalization has further drive the need for currency diversification for the need of international trade settlement.

Many investment experts now advocate and suggest that currencies as the new answer for a truly diversified portfolio. 

Currency can play an important role in the overall results delivered by a diversified portfolio. The benefits of holding foreign currency exposures can be summarized  as follows: 

• Foreign currency offers strong diversification benefits, reducing risk.
• Interest rate differentials of foreign currency denominated exposures can generate an additional layer of returns, called 'carry' trade.

For diversification, let's look at below chart. As demonstrated by the below chart, adding developed market foreign currency reduced the total fund risk. Interestingly, the impact of adding emerging market foreign currencies is only marginally less pronounced. Indeed for a reasonably large exposure there is a reduction in volatility.

Source: Perpetual, Bloomberg. Both live and back tested data has been used for the Diversified Real Return Fund. Results are for 31/12/1987 to 30/06/2013. Developed and emerging market currency baskets approximate the foreign currency exposures of the MSCI World ex Australia and MSCI Emerging Markets.

For 'Carry' return, it is a strategy in which an investor sells or borrows a certain currency with a relatively low interest rate and uses the funds to purchase a different currency yielding a higher interest rate. A trader using this strategy attempts to capture the difference between the rates, which can often be substantial, depending on the amount of leverage used.

As demonstrated by the below chart Australia has generally had higher interest rates relative to much of the developed world. This means that generally the carry for holding developed market foreign currencies would detract from performance. This is in contrast to many emerging markets, which have higher interest rates. Holding these currencies would have an improved impact on returns.

Source: Perpetual, Bloomberg. Emerging market currency basket contains Korean won, Malaysian ringgit, South African rand, Russian ruble, Polish zloty, Brazilian real, Mexican peso.

Now take a look at below graph, it will give you a very convincing reason why you should adopt currency diversification in your portfolio if the administration and financial management of your country are in a total mess. 

A strong, well administrate and managed with good governance country will be reflected by their currency value in international forex market.

Well, if I had RM10,000 in 1965 and kept in the bank of Singapore and assuming a risk-free average deposit rate of 3% per annum in this entire 50 years period, my savings would have grown to SGD43,839 and if I convert it back to RM now, the value after conversion would be a whooping RM119,680 with an average rate of return of 5.09% per annum. No bad at all for a risk-free investment.