An optimistic view of the dollar

The following is an edited transcript of a webcast held April 20 in New York. Evan Cooper, InvestmentNews deputy editor, and Jeff Benjamin, InvestmentNews senior editor, were the moderators. The webcast panelists were Marc Chandler, global head of currency strategy at Brown Brothers Harriman; Steve Meizinger, market operations specialist at the International Securities Exchange; and Ian Naismith, principal at Sarasota Capital Strategies. InvestmentNews: Marc, what is the state of the currency markets and where do you think things are going? Mr. Chandler: Broadly speaking, the outlook for the dollar is quite constructive. That is to say, the dollar is likely to rise. Often when we think about equities and fixed income, these are tied to the business cycle in some fashion. You're buying a claim on an income stream. In currencies, you're not. Currencies in their pure form have no value, except that the governments tell us they do. That is, they're not backed by gold or silver; we call them fiat currencies. In a broad picture, right now, the dollar stands on two legs. One leg is bad things in the rest of the world. Greece is having debt problems, and it is spreading out to other parts of Europe, especially Portugal and Spain. And there are other problems. Japan is still encountering deflation — that is, negative inflation rates. This has made the dollar look more attractive. When you buy a stock, you might think that IBM [Corp.] is going up, so you can just buy IBM. In the currency market, it's always about relative aspects of things. It's not the dollar in general; it's the dollar versus Europe or the dollar versus the yen or the dollar versus emerging-markets currencies. So one leg of the dollar is coming from bad things happening elsewhere. That is a strong leg for the dollar right now, because problems in the world are very challenging. The other leg of the dollar appears to be growing, but it is still the weaker leg: good things happening in the United States. As you know, the U.S. economy expanded at about a 3.5% rate in the second half of last year. The economy gained jobs. U.S. interest rates are rising relative to other countries, and rising interest rates are often thought to be one of the factors that help currencies. In the current environment, it seems that those countries that had the fastest growth and that are more likely to get central banks to raise rates, have stronger currencies. Australia has raised rates. Malaysia has raised interest rates. India raised interest rates this morning. Norway has raised interest rates. Israel has raised interest rates. Canada is likely to be the next one to raise interest rates, and the U.S. is probably further out, maybe late this year or early next year. But whenever it is, it's going to be before the European Central Bank, before the Bank of England and before the Bank of Japan. So that gives you a relatively optimistic view of the dollar, but one in which I think is more consensus now than when I first articulated it back in late "07, early "08.

U.S. IN BETTER SHAPE

InvestmentNews: Marc, we have been hearing that the deficit and budget problems are going to lead to a depreciated dollar, but even though we aren't in such great shape, the rest of the world is worse off than we are. Is that the message? Mr. Chandler: I would generally agree with that, but I would also think that the U.S. is in the best position to deal with the challenges. We are the only major industrialized country that has a positive fertility rate. That is, we're reproducing above the replacement rate, which is a positive development. We have flexible capital markets, unlike Europe and Japan, which are heavily reliant on bank capital and bank lending. We rely on the capital markets to help distribute capital. And so, yes, I think in general, we're better. It's not an existential crisis for the U.S., because we have a $14 trillion economy and because of these underlying things that make us better-positioned to address these challenges. InvestmentNews: So I guess babies are bullish for the dollar. Steve, given that scenario, let's say that an adviser has clients who want to take advantage of the situation. Tell us how he or she could do it. Mr. Meizinger: Well, options are a great way for investors to look at a lot of different markets. Today we're talking about the currency markets, and options are available in the currency markets. Given a view that the U.S. dollar might rally, investors can actually play that by looking at options. So they might look out at a one-month option, although they could actually go all the way out to a 10-month option — a longer-term view — and really have a limited risk. But currencies do cut both ways, so you need to think of it in that way. And again, the dollar bottomed out about five or six months ago against most of the currencies. What's happened, interestingly enough, is that volatility has declined because people are much more complacent about the markets in general. If we felt the dollar might rally, you might look at some call options. We saw a huge rally during the credit crisis as people ran back to the U.S. dollar. If you believe that the dollar might rally, you could simply buy a call option on this instrument, and you'd have a claim if the dollar were to rally. If the dollar were to sink — and this is one of the very, very important points about options — you have limited risk. If you're really, really long and the Canadian dollar surges against the dollar, you could only lose the premium that you paid. A one-month option with a dollar or so premium, all you could lose is the $100 that you put up. You might be able to make much, much more than that. There are a lot of different option strategies to implement, whether it's buying a call, buying a put for limited risk, hedging for a limited risk or even getting into more sophisticated strategies. It is up to each financial adviser to really look into the market. I look at volatility to try to see what everybody else is expecting. What we're seeing now is tremendous complacency that the world is on the mend, so option premiums are declining. That might create an opportunity for those of us looking for limited risk, because the option premiums are down significantly from 14 or 15 months ago when we were at the height of the crisis. What's interesting is that many, many people believe that the dollar is going to zero. I hate to say it, but there are a lot of doomsayers out there. The options market actually prices the reverse way to do that. If another credit crisis were to occur, people would flee back to the U.S. dollar to protect their wealth. And this is very interesting, as many people in the media think it's the reverse. But we saw in the last credit crisis that that's what happens. So options give financial advisers the ability to have limited risk. I'd urge all of you to really look into the options market and think about the currencies as an asset class in and of themselves. Options give you a great way to play it. InvestmentNews: Steve wanted me to mention that he has a very large number of slides explaining these things, and those are available on our website in the webcast archive at InvestmentNews.com/dollar. But let me turn to Ian for a minute. Based on what Steve said and the opportunities that might exist, tell us about what you do and how. Mr. Naismith: Actually, the way we do it is a bit different. First of all, those are very efficient ways to take advantage of different pairs, whether they're the major pairs or cross pairs of currencies. But when we talk to advisers, we find that only about 10% or less are even using the currency asset class. So what we decided to do is put together a model back in "07, and we ran the model live in "08, through the nasty fourth quarter of "08. And in that model, what we're using are different [exchange-traded funds], mainly from WisdomTree [Investments Inc.], Rydex [SGI], [Invesco PowerShares Capital Management LLC], so forth. And the good thing about that is that it gives the individual investor and adviser a way of getting into the currency market without having to tap into what they may perceive as a forex strategy or complicated options strategy. So it's important to take into account that you had the currencies of the G10 countries that you can choose from in ETF-land. You also have the emerging-market currencies that you can choose from. So if you happen to use any kind of technical analysis, you have a wide array of items that you can choose from in order to reach your goal of having return. So it's a totally different ballgame altogether. InvestmentNews: Ian, who is this for? Which client would be best suited for this? Mr. Naismith: Well, first of all, the currencies themselves — or if you decide to use an inverse ETF or mutual fund for the dollar — the idea is that currency as an asset class over a period of time is not going to correlate very strongly with commodities. They are not going to correlate very strongly with stocks, and they are not going to correlate very strongly with bonds. That means that they can correlate in the near term, but if you give them two or three years, you'll find that you'll have relatively low correlation. So one thing it's doing is that it's offering a different return stream for the adviser. Secondly, if they're using technical analysis, in which we are big believers, you know when to buy, and you know when to sell, based on the collective opinion of everybody in the world as far as what the price of that currency pair is. The idea with that is that you can reduce volatility substantially on that particular return stream. Not only do you get diversification into a different asset class, you also reduce the overall correlation matrix or have a different level of correlation — as in, almost zero correlation — and you can also bring down the overall volatility of the portfolio itself.

WHETHER TO CORRELATE

InvestmentNews: To get that correlation or lack of correlation balance, how much of a weighting do you need in currency strategies and currency positions? Mr. Naismith: Well, in our office, we have 15% in currencies. And while that may seem like a lot to some advisers, it may not seem like a lot to others. But I know that we were very, very happy back in 2008 when our model was positive for the year — it was up 5.7%. We were really happy to not have credit risk. And at one point in time, we drove it up to a 40% allocation. I think it was after September 2008 when the [Primary Reserve Management Co. Inc.'s] Reserve Fund broke the buck. And basically, what we did is cross-hedge against equities to get the money out of money markets. We also cross-hedged on currencies so that we would have a credit-proof portfolio. So it really is up to each adviser as to how much he or she wants in a portfolio. All you can count on, really, is that whatever allocation you're using, whether it's 5% or 15%, at least that part of the allocation is not going to correlate with the other broader part of the portfolio. InvestmentNews: Are you doing this in ETFs? Are you always long in ETFs as far as your weighting? Mr. Naismith: Well, you have to remember, each ETF has got a long/short component to it. So if you're buying FXA, as an example, which are the currency shares in Australia, you're essentially shorting the U.S. dollar against the Australian dollar. So in our particular case, we are both pro-dollar and anti-dollar. We don't care which way the U.S. dollar index is moving; all we want to do is capture the range of the movement itself. And that's the reason why for the last 10 and a half months, we're up in the fund, yet the euro is down, and also, the U.S. dollar index is down. So the only way you can really accomplish that is to put your money in commodity currencies, emerging-markets currencies, and be able to trade and be agile while you're managing the money itself. Mr. Chandler: I was just thinking who the currency market is appropriate for. I think there are two things to keep in mind. One is that the currency market is a 24-hour-a-day market. That is, my week begins Sunday night when New Zealand opens up ,and ends Friday at 5 p.m. when New York closes. What that means is that unlike, say, a stock like IBM or Google [Inc.] which, for the most part, trades during U.S. hours, the currency market is open 24 hours a day. The second thing about currency markets that is different from the equity market is leverage. The margin for equities is 50%. You want to buy $100 worth of stock, you'd need $50 upfront. In the cash currency world, your margin money is not set like a down payment toward your future purchase. Your margin money is a function of how much money you could lose in a day or two. In effect, your margin money in currencies is a down payment toward your future loss — that is, how much you could lose in one or two days as opposed to a down payment on your future purchase. This changes the game of currencies and why the equitization of currency makes the market more palatable — more accessible — to retail clients. But there still is this gap risk, and you do not get the kind of leveraging that spot people get that is in the over-the-counter market and the ETF. That is the gap risk. I think it's a serious risk, and that's why I think there's a whole issue of suitability. I would think that even though I fully respect the idea that currencies help diversify a portfolio and can lower risk, most retail clients are going to see currency exposure as added risk. Even if you only have 15% of your portfolio in currencies, that 15% should be the risk part of the portfolio, not the part of the portfolio that you need today or tomorrow. I think it's a risky asset.

VOLATILITY

I'll give you an example of the volatility, and again, volatility is how much currencies can move. During the 9/11 period, euro-dollar volatility got up to 14%. During the recent crisis, it got to 28%. So it can be very volatile, and again, because you don't have access to the market 24 hours a day the way that spot cash over-the-counter people do, you're sort of left at the mercy of when the New York Stock Ex-change is open or when the ETF market that you're trading is open. InvestmentNews: That is an interesting point about the risk. Steve, from your vantage point of seeing who is using the options markets and currencies, how do advisers look at this risk? Mr. Meizinger: Well, with the options market, you always look at perceived risk as volatility. As to how much an asset might move over a certain period of time, today the Canadian dollar is trading at 9% volatility. What does that really mean? It means that over one year's time, the dollar might move 9%. That is just a guess on how much movement we might have. It does not mean that it's limited to 9% or 10%. It's just a guess. About a year ago, it was much, much higher — about 18%. So the option premiums are a lot less. Mr. Chandler: Let me just jump in there for a second about the Canadian-dollar example. So if you're right — I think volatility is 9% — it means it can move 9% annualized over a 12-month period. Today alone, it's moved over 1.5%. Mr. Meizinger: And that's exactly right. So yesterday would have been a great opportunity to have an option, because you would have bought an option at a much lower value. So those are the opportunities in the options market, and the options are not overly complicated. If you think of an option, it's limiting risk, that's all it is. It's just like buying an insurance policy. Who should use these? Well, it's really about the risk reward of any financial adviser and their clients. What are they looking for? I can't tell you how much they should be looking at this, but think of options as a way to reduce risk, possibly bring in some income, and also have goals of maybe speculation with limited risk, because, again, markets can gap, and one of the biggest benefits of an option is that you do have limited risk. InvestmentNews: Steve, you mentioned doomsday scenarios for the dollar going to zero. What is the rationale for that kind of thinking? I mean, what scenarios have to happen for the dollar to go to zero?

IT'S ALL RELATIVE

Mr. Meizinger: Well, Marc made a great point — that currencies are a relative game. When I'm out speaking to investors, they often say they think of all the things that are going on here in the U.S., and they don't really look at it from a relative perspective. So they say, “Oh, the dollar is going to be worth a lot less next year and the following year because they're just going to keep printing money.” They're not thinking of the overall picture of what's happening in other regions and countries. What are their economies doing? So it really is a relative game. You need to think of it in those terms and think of what's happened, let's say, in the last two years. People were so convinced that the dollar would sink during the collapse of [Lehman Brothers Holdings Inc.] And I said, “You know, you never can be sure. It might go the other way.” When I look at the options market, there's a term called an “option skew” that tells you where the market expects volatility to be created over a longer period of time. In the currency markets, it's for the dollar rallying against most of the majors in a more volatile way. That gives me an indication of not necessarily direction but expected risk. And when I say expected risk, it's volatility. By that, I mean that if the markets get crazy again like they did 14 or 15 months ago and the dollar is moving up or down, which way will it be more volatile? It would probably be that the dollar would be gaining value, not losing value. If it's going to continue to lose value, it probably, at least according to the options market, will do so in a very slow fashion. But when it's going to gain, it gains in a very quick fashion. InvestmentNews: Well, I am assuming that looking at it through the prism of options trading, you are kind of considering shorter-term periods. But longer-term, don't all signs point to a declining dollar? Mr. Chandler: Maybe I can jump in here. I think that you're right; a lot of people would agree with you. I think that there are a couple factors that the big doom-and-gloomers look at. Foreign central banks hold something like $3 trillion or $4 trillion. They may get tired of holding those dollars. The OPEC countries and China may dump them. I see no evidence that that's happening, but some people are worried about that. Some people talk about oil being denominated in foreign currencies rather than dollars. Some people talk about the idea that, like the Chinese did over a little more than a year ago, that we should have a different international metric besides the dollar. It should be these special drawing rights as the International Monetary Fund created money. People talk about these things — that the U.S. is in overreach, the military is stretched, the consumer is tapped out, the government is heavily in debt, and this is the downfall of all great empires. I happen to disagree with that. InvestmentNews: Well, I am not suggesting the downfall of the dollar or the United States. But with the debt levels in the United States, rates are eventually going to up, and we are likely to see inflation. Doesn't the scenario over the next five years, at least, have to lead to a devaluing of the dollar? Mr. Meizinger: Well, not necessarily. Again, if you think of the markets, they're a relative game. So yes, some currencies are going to gain, some are going to lose. It's going to probably depend on their econ-omies; also their central banks. And if you think of where you might think the markets are going five years from now, it's not so much different than looking at IBM or Google. And if IBM was going to drop 40% before it's going to go up 80%, you'd probably want to be a seller before a buyer. You don't necessarily want to look at an investment over five or 10 years. I'm not saying you want to look at it over five seconds or five minutes, but if we're pretty certain that something was going to happen over a year or so, the options market would give you a great opportunity to implement that forecast. You could roll these positions, which would mean you could have it for two or three months, and you could actually sell them and then continue that strategy. So there are lots of different ways, and I urge all financial advisers to think about an intermediate-term approach — a year or two — not just a second, but not a decade either. InvestmentNews: We had a question about the situation in Greece and Spain, and the resulting recent strength of the dollar. Those kind of bumps come along out of nowhere, or even if they are expected, still have repercussions. How does that affect the dollar in the short term? Mr. Naismith: I think that what's happening is being driven by sentiment. So if you have news that's coming out every other day saying that Greece is going to be bailed out or helped out and then the next day, it's not, that itself affects the movement of at least the U.S. dollar index because 77.3% of it is made up of European currencies, and 57.6% of it is the euro. It has very little GDP effect on the euro at all, but it's a perception of those folks who are wanting to trade the euro against the dollar, which makes up over 25% of forex volume period, and that really has an effect. If you want to talk about public debt of GDP, you also have to look at Germany and France. They've been violating the Growth and Stability Pact limitations now basically since the euro has been out. They're not enforcing it, and if you look at a number of the different components of the euro, there are some problems there. So the idea is that if you want to take a U.S. dollar index perspective, which is what most advisers will dip their toe in, they're not going to jump into forex. They don't care if the market is up 24 hours a day or not. The average adviser is not going to mess with that. What they're going to mess with are items that they can trade readily, because they're not used to trading currencies. And the idea is that if Europe is or is not in more trouble than the U.S. itself, that's going to reflect itself in the U.S. dollar index, which is the most heavily traded mutual fund and ETF in currency-land at this point, at least for the average retail adviser. So if Europe deteriorates quicker than the U.S., it's going to make the U.S. dollar index go up — that's all there is to it. If the U.S. deteriorates quicker than Europe, then you're going to have the opposite effect. InvestmentNews: Marc, I heard you wanting to comment about Greece and Spain before. Mr. Chandler: Sure. Some people want to compare the situation in Greece to, say, the state of California and other states seriously in debt. Here is one big difference. No one is talking about California dropping out of the union. There are a lot of people concerned that Greece could drop out of the monetary union in Europe. And Morgan Stanley has said that Germany may drop out of the eurozone. The eurozone is a handful of countries — two handfuls of countries, actually — that have adopted the euro. Imagine what kind of turmoil there could be if Greece were to drop out. And I'm not convinced that even if they come up with a resolution for Greece, that the [crisis] is over. The market is going to turn its attention to what we call contagion risk, other countries that look a lot like Greece. The next one is Portugal, which is a small country relative to the size of the eurozone. But then you begin working up to bigger countries like Spain, which is something on the order of five or six times larger than Greece. They also have serious debt and deficit issues. So I think that the point about relative value is still spot-on. During the heat of the crisis in the second half of "08 through the first quarter of "09, the dollar was strong. From March of last year through November, as things healed, the dollar was set back. But now there is a new paradigm in foreign exchange, and the dollar has actually strengthened since November, so this is about the fifth month now that the dollar is strengthening. Even as stock markets appreciate, even as the world economy recovers, the dollar is not just a safe haven right now; it's actually a growth stock rather than a value stock. Mr. Meizinger: I just wanted to add one point about volatility, because when you look at the markets, if you don't look at volatility, then you really don't know what everybody else is looking for. And over the past couple of months, as Marc pointed out, people were looking at Greece and saying: “What could happen in a doomsday scenario if it drops out, if Germany drops out, or others?” But the one thing that has been interesting to me as a volatility expert is that the volatility in the euro versus the dollar has not moved at all. That means, of course, that option players think that somehow there will be some resolution. Maybe it's a short-term stopgap, as Marc alluded to, or maybe it's a nine-month or 12-month period. But at least in the short term, the option premiums are relatively low. Mr. Chandler: I would disagree, because I'm looking at three-month euro volatility right now, and we hit a high in late January, early February, of almost 13%, and today we're a little bit above 10.5%, and that has been down to 10% in the middle of March. That's a 30% swing from 13% down to 10% — that's a relatively big move. If it was a share of stock that moved 30% in the first quarter of this year, we'd say that's a good thing. Volatility has come down, and I think that this is where I would tie it into direction; as the dollar has gone up, volatility has gone down. And what I'm looking for is that the volatility gets perhaps a bit lower, maybe closer to 10%. I think of it like a spring, and they suck the volatility out, and the market is compressed like a tight spring, and then some kind of news hits, and we explode, and that's when we get big price action, as well as volatility adjustment. Mr. Meizinger: That's a good point. If you look at the dollar versus the yen over that same period, though, Marc, it was about 12% or 13% also. And I think — at least the numbers that I look at — the euro volatility is around 10% to 10.5%. So yes, it was trading at 12% to 12.5% down to 10%, but I would have expected a much higher number, considering the potential of Greece dropping out or Germany dropping out. Even with all of these scenarios, option premiums haven't really moved that much, which creates opportunities for people who believe that something really big might happen. That might be an excellent opportunity to be a buyer of an option. InvestmentNews: Where do emerging-markets countries fit into this? Mr. Chandler: You look at the currency ETF, and there's not a lot of exposure to the emerging markets. I believe Rydex currency shares have the Russian ruble, and there's the Mexican peso. But what we're seeing is that most people who are trading in emerging markets are interested in two things right now. One is capturing high yields. So that would be countries like Brazil. It would be countries like South Africa or Turkey or Hungary. Countries do not give high yields because they're being generous. The market demands it from them to compensate for some other risk. So many times, the emerging markets as a pure currency play are not really available to most retail investors. Second, I would say that in an emerging-markets space, what people seem to want to do is [be long on] the Asian currencies, partly because they are in a sweeter spot, if you will. They are experiencing rising price pressures, and therefore, higher interest rates are likely coming. They also are tied into the Chinese economy directly. China becomes their biggest trading partner and many of the Asian countries' biggest trading partner. And third, as we saw with Intel [Corp.'s] earnings, these countries like South Korea, Taiwan are also very much tied into the U.S. technology cycle. So I'd say that generally speaking, in the emerging-markets space, people are most optimistic about the Asian currencies, and there, perhaps, the indirect way for people to be able to play them, again, in the ETF space is buying the country index, which gives you currency exposure to those emerging markets. In terms of Latin America, [you have] the Brazil story, which is still very attractive, high interest rates and the commodities story. The problem, though, and why a lot of foreign investors are slowing down buying Brazilian stocks, is that there is an election coming up. They've had a huge stock market rally, and they're worried about the pre-election sort of fiscal policy excesses that sort of juice the elections.

EASTERN EUROPE RISK

I think most people would be more negative to Eastern European currencies. That would even include Hungary, a high-yielder, the Czech Republic, perhaps Poland a little bit as well. Russia is seen as an outlier, because many people see it just as a large oil [reserve] or gas station, and so there is a high correlation between oil prices and the Russian ruble. InvestmentNews: And Ian, what is your view on the emerging-markets currencies? Mr. Naismith: I view them quite positively. Basically, they have given us the majority of our gain for a while. We don't try to figure out what's going on in the future. We choose to react to what we call the recent past. There are some matrixes or analytics, or whatever you want to use, that will give you sufficient price movement gain if you're investing in ETFs, and call you out of that investment in what I would consider relatively successful fashion. As an example, I just pulled up Mexico because someone had mentioned Rydex Mexico. And if you just look at the trailing 20 days, is today's price on that ETF greater than it was 20 days ago? If it is, hold it, all right? Well, I mean, this is very simple. This is just one of the many metrics that we use [when] trading in our mutual fund. But the idea is that in May of 2008, you're in at $95 or $96, and you called out at $99 right before the crash, and you sit out throughout the whole crash, and you get back in at $76. Well, what that has done is, it has eliminated a lot of guesswork and prognostication and headaches and everything else that goes with trying to figure out what's going to happen in the world. I mean, we can't predict what's going to happen next week, much less what's going to happen a year from now. So our feeling is, use the recent past, be agile and move in as you need to, and you shouldn't have that many problems. InvestmentNews: What tax accounting issues should financial advisers be thinking about when it comes to currency trading? Mr. Naismith: Well, it just depends on what you're trading. If you're doing ETFs, you have the capital gains that come along with trading. But the IRS passed the rule back in late "07, I believe, in terms of the treatment of gains within ETFs. But again, we trade these within our fund, and therefore, we divvy out the gains as we need to, so I just look at it through different eyes altogether. I don't get caught up in the code so much. InvestmentNews: We are getting a few questions on how to get started in currency trading. Somebody asked if there is a specific book that you guys could recommend. But before we get to that, is there an ETF or a couple of ETFs that an adviser could use to plug into a balanced portfolio? Mr. Naismith: At the very basic level, if you're trading UUP [PowerShares DB U.S. Dollar Index Bullish Fund] and FXE [CurrencyShares Euro Trust], what you're doing is, you're capturing, again, over 25% of the volume in forex. So when you're trading UUP — and I'm talking about buying them long in the portfolio even though there's two sides to every story on these things — you're essentially shorting six different currencies, 77% greater in Europe, and then the other components of the index itself, which would be the yen and also Canada. So the reason why I'm bringing that up is because the UUP and FXE have less volatility on an average basis than all the other currency ETFs out there, period. InvestmentNews: The UUP and FXE, those are ETF tickers, right? Mr. Naismith: That's correct. When you're buying FXE, basically what you're doing is, you're shorting the U.S. dollar against those six currencies within the euro. So they have less volatility than the other ETFs, with the exception of CYB [WisdomTree Dreyfus Chinese Yuan Fund], which may have more volatility later if they decide to unpeg that thing. So that would be a good place for them to start. It's not the end-all and be-all. I believe that you should have a basket of different currencies that you're trading, such as using the commodity currencies, using the emerging-markets currencies, European currencies and using the U.S. dollar index, and hence the reason why we started the fund. InvestmentNews: Steve, where could someone get some information about options trading in currencies? Mr. Meizinger: At fxoptions.com, we offer all kinds of different tools and different resources. We have weekly webinars on Tuesdays and sometimes Thursdays, in which we bring in special guests to talk about the currency markets and how investors can trade right through their equity options account so they won't need a separate account to trade these options. InvestmentNews: And Marc, from your perspective in the institutional world, what kind of information sources would you recommend for someone getting started? Mr. Chandler: I would actually begin at a more basic level. I think that it's hard enough for us to trade stocks until we're familiar with the companies. Information from companies is very difficult. And when you're dealing with currencies, I think even if you want to be a pure technician and look at past price action to figure out when to buy and when to sell, it seems that for suitability reasons, you would want to be able to tell your clients a story about what's going on with policy or, for example, Thailand stock went up 5% last night after being down about 20% the previous three weeks because of political crisis there. And if you were to trade something like that and you see it's up one day, you need a story. And I would suggest reading the currency columns every day in The Wall Street Journal and the Financial Times. They talk to people and identify what are the forces of movement, what's driving the market. And second, you learn the jargon as well as becoming comfortable with the fundamental story out there. And my sense is that having begun my career on retail, clients like stories. You telling that there's a head-and-shoulders pattern, that they're buying the dollar index and buying the UUP, I don't think is as convincing. People tell me, “Don't sell the steak; sell the sizzle,” and I think that you need a fundamental story, and you get that fundamental story by reading, reading, reading. Whether it's the Financial Times, Wall Street Journal, there's tons of Internet websites to learn the fundamental story. That's what I would encourage people to do. Like Euclid said, “There's no shortcut in learning geometry.” There's no shortcut in learning foreign exchange. InvestmentNews: I am going to go back to that dreaded long-term declining-dollar scenario that everybody likes so much. One of the listeners has asked about which asset classes to be in over a long-term declining-dollar scenario. I don't know if this is something that you guys are comfortable talking about. What are the hedges against the long-term declining dollar? Mr. Chandler: Again, I think we might have to consider that it's not just the dollar against whatever. If the dollar is going to fall for the next 20 years against China, it might be a lot different of a strategy than if the dollar were to fall for the next 20 years against the euro. InvestmentNews: What about a client who thinks that the dollar is going to be declining steadily over the next several years? Is there a place that investors can go to hedge that — gold, maybe? Mr. Chandler: If someone has expenditures in U.S. dollars and liabilities in U.S. dollars, and has their 401(k) in U.S. dollars and is going to retire in the United States, what does it matter if the dollar is going up or down against the South African rand? It comes down to what the client needs. But generally speaking, most of your clients, I imagine, have dollar income and dollar liabilities. So trading foreign currency is taking on a new risk. It's not really hedging your risk, because you have no risk. You don't care about what the dollar does against South Africa, because you don't have any rand investments, you don't have any rand exposure. So I think that if you're thinking about a way to profit from a falling dollar, and that kind of scenario, I'd say buy foreign assets. But if you just are thinking that: “Well, the dollar is falling against the world, and I need to protect myself,” I really think you might rethink what the real issue is. You don't have a currency exposure, you don't have a currency mismatch. If you're going to get involved in currencies, you're doing it not for a hedging reason but because you're really speculating, and that's a different story.

WHAT DRIVES PRICES?

InvestmentNews: One other thing I wanted to ask about is, what is driving currency prices? Is it supply and demand, inflation? Mr. Chandler: There are several different factors that economists would look at, such as inflation. Right now, I'm suggesting to you that the key driver is not so much risk aversion like it was during the crisis. During this crisis, we created a big gap between how much we can produce and how much we are currently producing. Economists call that the output gap. I am suggesting to you that the major force in the foreign-exchange market now is who can close the output gap the fastest. Those countries that can grow the fastest will get higher real interest rates, they'll get higher earnings, better profitability, rising asset prices and attract foreign direct investment. That's the key driver. Now, on the other hand, you might want to say that the other driver is concern, say, of default problems in Europe. The more Greece has to tighten up its budget, the more Spain has its fiscal austerity measures, the slower they're going to grow, the longer it's going to take to close the output gap, the longer the gap then is between the U.S. Federal Reserve rate hike and the ECB rate hike. I would acknowledge that over time, the currency market is prone to different drivers. Right now, I'd say it's a growth driver. I've been around long enough to know that sometimes it's been trade as a driver, sometimes it's been the unemployment number. That number tends to set the tone for the whole month. But I think that we're now in a growth phase, a growth driver for the foreign-exchange market. InvestmentNews: Does anybody else have any thoughts on what drives currencies? Mr. Naismith: I'll just pipe in. It's the sentiment that encompasses everything that Marc's talking about and also, I think, that forex is very technically driven. You talk about people following different types of indicators and different kinds of pivot points and things of that nature. So how much is driven in terms of volume from each one? I don't know, but I do know that both of them are heavily involved. Mr. Meizinger: One thing that novice currency investors want to do is invest in the highest yielders. That concept is not that dissimilar from looking at the highest-yielding stocks. In the equity market, the highest-yielding stocks might have the most risk, as might the highest-yielding currencies. So while interest rates do drive currencies, there are a lot of factors to consider. Mr. Naismith: Well, another thing can happen. For example, the carry trade, which had been working for a number of years, totally blew up in 2008. It fell almost 40%, and the catalyst behind that particular trade is going with the high yielders and the G10 and shorting the lowest yielders in the G10, at least in the commercial sense. And so the idea, again, is that practical and prudent advisers, regardless of what they think is going to happen in the future, really need to use risk management tools so that they don't have to try to explain why they thought something was going to happen that didn't, and they're looking at their client, saying: “Well, I'm sorry you're down 38% and 40%.” Regardless of fundamental or technical analysis, make sure that you have a safety net.

BUYING AND SELLING YIELD

Mr. Chandler: I think that essentially, there are three types of strategies. I'd say there's the carry trade that we talked about; that's buying the high yielder and selling the low yielder. There's momentum trades in which you would want to buy the currency that's going up and sell the currency that's going down. That's trend following. And the third type is a mean reversion strategy, which is buying weakness and selling strength, the opposite of the momentum or trend followers. When I look at trade strategies, it seems to me that almost every trade strategy I've seen fits into one of these three buckets. And so some portfolio managers I know might run each one of these portfolios. Now they've got a currency portfolio with a momentum trade strategy, with a carry trade strategy and with a mean reversion trade strategy, thereby, having a sort of a comprehensive currency play, if you will, one portfolio with three different buckets in it. Mr. Naismith: One thing you have to be careful of, though. We use about 20-plus algorithms in the fund. The way we do it is, we know that a lot of times, a lot of them won't work, and we don't want to work with things that are not working in terms of measurement tools. So the idea is to get as many measurement tools as you possibly can from a technical aspect, compare those measurement tools as you look back 20 to 50 trading days, and go with the ones that are working in the environment. And you'll be surprised how much bloodshed you can sidestep if you're using the things that are working at any given moment. So a mean-reversion technique may work well. It's gruesome in a down market or a linear down market. Momentum works well, but the problem is, what are you using to determine your momentum, and how are you going to throw in your risk management in the momentum when it's not working any longer? So the idea is take as many indicators or strategies as you can and put them against each other, make them compete. And whichever ones are working, those are the ones you want to lean towards. Mr. Meizinger: Yes, I'd agree. You always want to think in any kind of strategy, what is the worst-case scenario, what is the best-case scenario? And there are drawbacks to all the three buckets, as Marc put it, and there are benefits. And that's what investment advisers need to think about for their clients — what are the risks, what are the rewards? Suitability is very key. InvestmentNews: Marc, you mentioned that most U.S. investors have income coming in dollars and obligations going out in dollars, so there is no need to worry about hedging. What would you say in situations where an adviser has a client who is retiring outside the United States? Mr. Chandler: If you have some clients that have some foreign-currency exposure, either in the asset side or the liability side, they have a different position. I'm not sure that in that case the currency ETF, the securitization of currencies, is the most efficient vehicle for that. The spot market — that is, the cash market — which has a wider range of currencies, might be more appropriate. For example, right now, one of the countries that I would like to retire in is Brazil, and it's very hard for me to take a pure Brazil currency play in the ETF space right now. Perhaps down the road, it will be more available. But again, if you think about what the ETF gives you, it might protect you from currency movement. But the problem is, if you're living in Brazil, you need reals to pay your landlord or to pay your mortgage. Buying an ETF might make your dollars whole, it might preserve the purchasing power of your dollars, but it still doesn't give you the Brazil reals, and that's what the cash market does. Mr. Naismith: Yes, an ETF doesn't make sense in that particular instance — I agree with that. Basically, you're looking at spot exchange rates, investment market value of whatever you're trying to protect. Then you look at futures prices, and then you take your actions, depending on what you're seeing there. So as an example, if there's a scenario where you're in Brazil and you're wanting to protect the dollar value of a Brazilian-real-dominated investment, the dollar appreciates 10%, and you've got it hedged out in the futures market using the real. What you can do is really reduce the amount of purchasing power, the effect of the decrease of purchasing power. So buying an ETF does not make sense if you're trying to hedge out. They're really, as far as we're concerned, directional-movement types of items. InvestmentNews: Gentlemen, before we close, I just want to go around and ask each of you for some takeaways that you could leave with our attendees today. What about currency investing? Steve, let's start with you. Mr. Meizinger: Well, first of all, suitability. You really need to, of course, think about what's right for your client. Options offer limited risk, so if you wanted to have a view on a certain currency pair, you can do that with options, and you don't have to worry about the tremendous gap. In fact, if you're a buyer of an option, all you could lose is what you paid for the option. You really want to understand option strategies. You'd never want to get into a trade until you understand it. But I think that it's a very exciting time, as options are available on currency pairs. You just need to have an equity options account, and you can trade these, whether it's for a short-term or even an intermediate-term basis. InvestmentNews: Marc, last thoughts? Mr. Chandler: I agree completely, suitability. I think it is really the most important issue in general to show clients currency-type strategies. The other thing that came out from our discussion here that I would underscore is the importance of risk management. People who are right more often than not are not going to always make money in the market by being right more often. People who make money just are more disciplined risk managers, and I think risk is a very hard concept in a market that trades 24 hours a day but in which you have access for only a few hours. InvestmentNews: Ian, your last thoughts? Mr. Naismith: Well, I agree with what they're saying. But I also think that advisers shouldn't be paralyzed, meaning that you've got to remember that most advisers are going to use funds or ETFs prior to using forex or futures or options. That's just the way it is. And so when you're doing your due diligence, make sure you understand the different types of benefits that being in the currency asset class can give you, versus commodities, stocks, real estate, bonds and so forth. And again, I mean, we're experts at managing risk, and so we really concentrate on making sure that the drawdown is very low in the fund and also in our regular asset management. And I would implore the average adviser to define what they're willing to lose, and have the plan in place to keep it from going any lower than what their plan is. The audio webcast and slide presentation are archived at InvestmentNews.com/dollar.