Merk: Beware Quick End To Low Volatility

May 30, 2014

ETF.com: How can investors protect themselves against these issues?

AM: The question as an investor is what is your goal and how are you going to implement this?

The first seismic shift that has happened in the euro – which people aren’t all aware of – is risk is generally being priced locally again. This may sound arcane, but it makes the world of difference. When Cyprus blew up, Spain had a treasury auction where they paid the lowest yield since the early 90’s. It means that the next time a crisis flares up, odds are, it is going to be a local crisis and it doesn’t need to swap the currency. So another question is do you want to play the euro or the yields, what’s the play?

We don’t think that it is prudent to chase yield in the current environment where we are seeing complacency as a global theme. Asset prices in general are also very vulnerable, because - in my view - at some point the tide is going to turn and the glass will become half empty.

ETF.com: What do you think of currency hedge ETFs?

AM: It is a big theme this year. The Japanese helped to get that market started, because last year if you hedged the Yen out of the Nikkei you had gangbuster returns. Year to date it hasn’t worked.

Generally speaking about 30-50 percent of market returns are due to currency and that can be due to upside or downside. So, if you hedge it out you leave a big chunk of the return on the table. It can reduce the volatility - sure, but you leave the returns on the table.

If you don’t hedge it out you are in for a rough ride. My view is that you should actively manage the currency risk of your portfolio, including your international equity portfolio. We live in a world where asset prices don’t reflect fundamentals, because we have active policy makers, on the policy side, the fiscal side and the regulatory side. The currency market often expresses the next policy action and therefore it’s important to manage this and by hedging it out – in my view – you don’t get much of an advantage.

ETF.com: Enough tools for investors to know how to manage currency risk?

AM: Not really. Part of the reason is that most people stay away from currencies because they think they don’t understand them, so there hasn’t been much demand for them.

The currency space is one market people can get true diversification, but people don’t understand it and don’t take the effort to get to know it, so a lot of people are just listening to the pundits and they come up with some ideas that we have a rising interest rate environment, so the dollar has to go up. This is historically that is bogus.

People are just not very critical when it comes to currency and it is why these currency hedge ETFs have become very popular without people actually doing their homework or analysis.

I am not saying that people shouldn’t use them, but if you do then you have to take another sleeve of your portfolio that focuses on that currency risk.

ETF.com: Are these appropriate for retail investors?

AM: Well, we think so.

People always say currencies are speculative and volatile. The reason people think currencies are so volatile is because a lot of people use leverage in the currency space. But you don’t have to use leverage.

 

 

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