Notes on Foreign Exchange

A reader recently asked my opinion on foreign exchange (forex). It depends, really. Banking on short-term fluctuations or active trading is financial suicide. But as a mechanism for parking a portion of one's excess cash not needed in the medium term (6 months to a year) it's not a bad idea and I actually encourage it.

Short Term Speculation

Anyone engaged in day trading or active trading in forex is losing money, necessarily. Forex is a zero-sum game for investors -- one side must lose in order for another one to win. But there's more: spreads, taxes, and commissions make it necessarily a losing game.

Not only that, but foreign exchange rates are thought to be even harder to predict than short-term stock movements. If you thought it was hard to value a company, imagine a country or a group of countries as is the case with the Euro. There's just too much going on -- policy setting, politics, lobbying, international interference, international trades, changing laws and even wars and natural disasters.

Stay away from short-term speculation on forex.

Medium-term cash parking

If you have excess cash (and you should, for your emergency funds), then diversifying away from your local currency is like buying insurance against three things:

  1. Government actions (jurisdictional diversification)
  2. Inflation
  3. Major catastrophes (natural or man-made)

Government action protection only works if you pick currencies from countries with a reasonable political history. It protects you from arbitrary actions taken by a governments that could adversely affect the currency, such as import taxes, interest rates, or even outright confiscation.

Inflation is listed again separately from government action because it's such a common threat. It's the invisible tax. A basket of currencies can help mask the effect of a single inflationary country devaluing your hard-earned cash.

And of course, if something terrible happens to a country, having some exposure to other currencies can mitigate some of the negative effects.

I currently don't put a lot of faith in the US dollar, so I believe it makes sense to have some exposure to other currencies (gold was discussed here).

Guidelines for investing in foreign currencies

So, what do I recommend? First, when possible, tilt your allocation towards currencies that earn some real (after inflation) yields. The Swiss Franc right now yields 0%, while the Australian dollar yields over 3%. You might as well get paid to wait.

Second, pick countries with a history of maintaining their stability and buying power. In this case, the Swiss Franc is a good option and it is also partially-backed by gold.

Third, choosing currencies whose countries have lots of varied natural resources may provide some comfort about the currency's attractiveness in international markets. Some options that come to mind are Australia, Canada, Brazil and South Africa.

Current opportunities

My current cash diversification is pretty bad and I don't recommend anyone follow it. Given what I just wrote, I will follow my own advice and diversify further. But just because you asked, my cash reserves are currently split as follows: 12% in Brazilian Reais, 6% in Australian Dollars, 4% in Canadian Dollars and another 4% in the South African Rand. The other 74% are still shamelessly in US dollars (in my defense though, I do have international stocks traded directly in foreign stock exchanges in their native currencies).

Until recently I was recommending CDs backed by a basket of foreign currencies, but I found that option to be cumbersome and not very fee-friendly or transparent so now I'm sticking with currency ETFs such as FXA or direct investment in the target countries (to take to the extreme the jurisdictional diversification).

FXA, by the way, is down 3% from last year's averages and yielding more than 3%.

Disclosures: Long FXA.


Infrastructure Opportunities in Brazil

To spur economic activity in Brazil, the government decided to do something unique: it opened up basic infrastructure projects (railroads, energy, roads, ports, etc) to private investors to use their retirement funds.

Explaining the deal

Let's go in parts: in Brazil, employers must contribute a fraction of their workers' salary to a tax-free account, which such workers can only use in very specific circumstances (buying a house, involuntary unemployment, etc). The money in such retirement funds are typically restricted and can only be invested in a few investment vehicles tightly regulated by the government, such as savings accounts and CDs. Therefore, it's no surprise they don't earn a huge return compared to all the options that would be available were such restrictions inexistent.

Now, in order to heat up the much needed area of infrastructure development, the government is allowing workers to invest part of their retirement funds into selected infrastructure projects.

What does this have to do with non-brazilian workers, you ask? Everything. Why? Because the companies poised to gain from these government-lead efforts are many and if brazilian investors join the bandwagon these companies should ring nice profits in the next few years.

The bad news

The bad news is that many of these builders and engineering companies are private and as such are very hard to invest in directly. They are the likes of Grupo Votorantim, Queiroz Galvão, Camargo Correa, and Odebretch.

The good news

The good news though is that some are public and even the private ones sometimes hold smaller subsidiaries that are publicly traded. For example, the financial arm of Grupo Votorantim, Votorantim Finanças, emits bonds from time to time, while Queiroz Galvão's subsidiary Braskem is publicly traded under the symbol BRKM3 -- though, Braskem is in the plastics and recycling business.

Camargo Correa also holds several companies, some which are public, such as ticker CCRO3, which is in the business of maintaining roads and commercially exploiting their toll booths. With more roads, toll booths are sure to boom too.

Finally, there are is one company left that is publicly traded and directly into the construction business: Andrade Guitierrez, which trades under the ticker CANT3B.

Sadly though, none of these are available as ADRs in the US. However, a strict ADR investor can still get some fringe benefits by investing in basic materials and exploration companies, such as chemicals company Braskem (ADR symbol BAK), Steel companies Gerdau (GGB) and Siderúrgica Nacional (SID), mining company Vale do Rio Doce (VALE) and homebuilder giant Gafisa (GSA). A far away alternative would be ETF EWZ.

None of these investments though are sure things, of course. These are just starting points. It's possible that these companies are overvalued and that the boon due to the new government-sponsored infrastructure projects have already been factored into their prices. Do your own homework before investing.

Disclaimer: I own GGB at the time of writing.