Diversification is critical for long term portfolio health. We’ve all heard about the benefits of not “putting all your eggs in one basket,” but conventional wisdom needs to be updated every now and then. The modern investor has a wealth of new tools to achieve real diversification. Small retail investors are encouraged to spread their portfolios across a range of different types of stocks and bonds. Small caps, mid caps, large caps, value, growth, short and long-term Treasuries, and municipal bonds have been the staple of a diversified portfolio. Well, times have changed and so too should your notions of eggs and baskets.

With the emergence of exchange-traded funds (ETF’s) there has sprung forth tremendous new tools for diversifying individual portfolios. Stocks and bonds can now be supplemented by precious metals, natural gas, oil, agricultural commodities, real estate, sub sectors of the economy (retail, financials, energy, etc.), targeted global markets, and currencies. Currencies, in particular, offer individuals a powerful alternative for hedging inflation and the decline of the US dollar, and adding a new level of diversification to offset adverse movements in stocks and bonds.

Portfolio theory suggests that adding minimally or negatively correlated assets to your portfolio can decrease overall portfolio variance, or risk. The second term in the following equation illustrates that negtaive asset correlations reduce overall variance:

You can click on the equation for a detailed explanation of the terms and characteristics of the variable relationships. The following correlation coefficient matrix shows how select currency ETF and stock market index returns move in relation to each other:

The stock indices analyzed were the Dow Jones Industrial Average (^DJI), S&P 500 (^GSPC), and DJ Wilshire 5000 (^DWC). These were compared to Euro (FXE), Swiss Franc (FXF), Canadian Dollar (FXC), Australian Dollar (FXA), British Pound (FXB), Japanese Yen (FXY), Mexican Peso (FXM), and Swedish Krona (FXS). Weekly return history was analyzed over time periods ranging 12/05 or 6/06 to present, depending on the inception date of the ETF. Click here to view the spreadsheet.

This analysis shows that Swiss Franc, Japanese Yen, and Swedish Krona have negative correlations to US stocks, while Mexican Peso, Australian Dollar, and Canadian Dollar are positively correlated. To get the most out of diversifying a US stock portfolio, it would be advantageous to include the former and exclude the latter. However, there are other reasons to invest in currencies, such as hedging declines in the US dollar. The following chart shows how each of these currencies has performed over the last year relative to the dollar:

You can see that holding Swiss Franc, Euro, Yen, or Krona would have yielded roughly between 12% and 17% in capital appreciation. Not only that, but each ETF has a dividend yield, representative of interest rates within each country. The following table shows current yields:

An income investor should consider holding Mexican Peso, Australian Dollar, and British Pound, while avoiding Yen and Swiss Franc. You can see there are many factors to take into consideration, but applying basic portfolio theory to your own holdings can have signficantly favorable long term results. Currency ETF’s offer a great alternative to traditional methods of diversification and are great to offset further declines in our own currency. Consider that commodities price growth is largely attributable to US dollar depreciation and you can see how foreign currencies can insulate individuals from energy, food, and other commodity-driven inflation. Thank goodness for Capitalism!

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Americans should be afraid of the long term value of the dollar. The country has massive fiscal imbalances that only look to be worsening. The social-political trajectory we are on is not likely to change, so a prudent thing to do is start transferring assets out of the country. A great way to do that is to buy foreign currencies. Exchange-traded funds (ETF’s) allow the regular investor to gain exposure to a variety of the world’s largest currencies, including Euro, British Pound, Canadian dollar, Australian dollar, Japanese Yen, Swedish Krona, Mexican Peso, and Swiss Franc.

The great thing about currency ETF’s is that they are passively managed, pay dividends, and are structured to mimic the movements of their respective currencies. Portfolio theory suggests the best way to lower risk is to diversify, but stocks are correlated to other stocks, and all stock markets around the world are tied to each other. Going into bonds is useful, but then you sacrifice yield, which should be an important consideration for the young investor. Currency ETF’s are a great candidate for a long term portfolio, particularly because they have minimal correlation to other assets.

Correlations were derived using weekly return history relative to the Russell 2000 index of U.S. stocks. A perfectly correlated asset, with a 100% value, would move exactly the same as the stock market, while a perfectly negatively correlating asset (-100%) would do the exact opposite. The above table shows that currencies have little in common with stocks, meaning they are great candidates for your portfolio.

Keep currencies in perspective and add them to your long term holdings in moderation. Asset class diversification is key, so don’t overweight in any particular area. I also recommend choosing a small handful of currencies, since they are all extremely correlated to the U.S. dollar, and hence to each other. For instance, from the same data set as the above calculation, the Euro and Swiss Franc are 85% correlated. It would not make sense to add both of them to your portfolio.

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