Macro Economics
A Multi-Dimensional Approach to Asset Allocation

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By washcomp
October 12, 2009

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A multi-dimensional approach to asset allocation. Foreign investments are more frequently discussed than previously, but I still think that the average US investor is not comfortable plunging in, but is still tip-toeing on the periphery of this territory.

I know this reads like an essay (sorry Andy :-), but I wanted to be careful to explain the concept in terms that would be understandable and reasonably complete.

The following concept was developed from an email to a friend to introduce a concept which parallels the way I look at asset allocations. I know I have been appearing to pound the drum about foreign currencies, but this was done out of context. I'd like to expand my thoughts a bit and would like some feedback on whether you think I should work toward a formal set of relationships on this concept.

There are a number of reasons why I consider foreign currencies a separate asset class. They serve the same purpose as cash in a US oriented portfolio in a sense.

Let's for simplicity's sake, let's ignore a wide variety of asset classes (including, for example, real estate, commodities, semi-monetary precious metal, etc) and limit ourselves, for now, to US stocks, bonds and cash. If I structured a "two dimensional" US diversified portfolio I might expect to find some fixed income stuff (maybe some tax exempt, some TIP, some corporate long - whatever), a mixture of equities according to whatever scheme I would be using, and some cash. IMHO, people turn their nose up at cash, but managing it properly can allow it to perform at about the rate of inflation without the risk inherent in equities (or even bonds if interest rates rise - as they must as surely as they fall) and thus provide inertia for the faint of heart. Within a two dimensional universe of a single countries equities, debt and cash, we can comfortably understand the relative risks and benefits of each.

As many investors who followed the financial industry's template of "keep as much cash as you would need for an emergency and invest the rest in a diversified portfolio" was devastating to their net worth at the end of 2008. Cash is good (especially as long as we are in a deflationary period).

Now let's expand this structure into three dimensions by adding the variables of currency ratios. (I'm again going to ask your indulgence and make the assumption that the equity/debt companies we are discussing are not selling "globally" as this confuses the discussion - we can discuss this afterward).

And, for the heck of it, let's pick an extreme example of a country with an ever appreciating currency, but whose stocks have lagged for the greater part of a generation - Japan. If you had "invested" in Yen, you would have way outperformed the Japanese equity market.

I'm not going to recommend any particular currencies at this point. Some of the stronger ones have "issues" which make them less desirable, some are easier to open accounts in than others, some are more closely linked to the USD than others. That's not the issue of this post. What IS important is each currency is valued as a ratio (to the USD as well as against each other). We'll come back to the importance of this with respect to multinational corporations later.

I am not against foreign stocks (and usually they make up a very large proportion of my equity portfolio), but especially in times like these (equity market over-valued, but still expecting a long economic downturn), the risk of inflation in terms that could affect me are nominal. In this context, foreign cash offers reasonable interest rates, stability as compared to foreign stocks and bonds, a hedge against a dropping dollar and geographic diversity if it hits the fan over here.

I promised to discuss global companies, so here goes. The relative business that they do in each currency area or zone will give you a clue as to how likely they are to benefit from a strong currency. A foreign firm who does half of their business in the States will only be exposed to ½ the exposure of a foreign "domestic" company (say the largest Turkish cell phone service provider, as an example). The reverse is true of US multinationals who do substantial parts of their business abroad.

Foreign bonds fall into two categories (from our standpoint) - those valued in USD and those valued in some other (possibly not native to the borrower) currency. Two factors are important here in determining the desirability of holding the bond (or a fund specializing in a class of bonds) in your portfolio: The safety of the borrower (using all the relevant methods, such as rating, maturity date, etc. of determining that portion of the valuation) and your expectation of the movement of the bond's currency against the USD.

Physical precious metals in small quantities may be useful if the world as we know it comes to an end, but in today's environment, (at least outside of Southeast Asia) you can't buy anything with gold directly (and first have to convert it into "real" money). Miners may do well if the dollar drops, but they are a different asset class from foreign cash. I would recommend considering that the nationality of a mining company is less important than their cash flow/assets in-the-ground, cost of mining, etc. Since both solid and liquid commodities are valued (at least for now) in US dollars, while they may be a reasonable hedge against a drop in the USD, they are not affected by the value of their "corporate" currency against the dollar.

Foreign currencies offer the same type of inertia to foreign stocks and bonds that US cash did in our credit crisis. There are risks involved, but if you select countries with a low probability of political issues, the risks are based on your guessing wrong and the dollar increasing in value. This, in some cases (Aussie come to mind) can largely be offset by the higher interest rates the foreign account pays if things swing the other way. If the dollar tanks, the currency hedge may save your butt in places that physical precious metals may be awkward to use.

I think it is prudent for a resident of the US to have alternatives (including geographic) at this stage of the game. Currencies offer the ability to not only have almost immediate liquidity, by the ability to wire those funds (converted to the currency of your choice) to any financial institution in the world. (I suspect that neither Everbank nor Interactive Brokers would be able to carry this task out if the US dollar was in extremis, and therefore I prefer foreign bank accounts in stable, well financed, well insured banks abroad - yes, banks DO exist which meet these criteria in the places I am interested in).

I understand that an asset allocation which involves the third dimension of price fluctuations based on changes in currency ratios sounds like it complicates matters. Actually, the reverse is true. If forces you to concentrate on a factor which has great effect on the profitability of US multinational companies as well (and give you a clue how their earnings are likely to appear the following quarter. We live in a global environment, whether we like it or not. Evaluating ourselves on how we are doing in terms of our native currency will put shackles on our wrists in many financial scenarios. Sure, you have to measure your performance in "something" and the USD is as good a benchmark as anything (though there are probably some of you who would prefer to measure your wealth in ounces of gold - if so, then go for it). It really doesn't matter what you measure your NAV in as long as you are maximizing your probability of growing it within the (in my opinion more important) context of minimizing the likelihood of losing money. It is far harder to make back a lost dollar, than not to lose it in the first place.

I'm not evangelizing this idea (though I guess the above sounds like a sermon), just pointing out that foreign domiciled cash is an alternative that few Americans think of as an investment asset class, and that it may offer less volatility than foreign stocks or bonds as a hedge against the dropping of the greenback.