Merk: Why Currencies as an Alternative

You have the liquidity, dwarfing the liquidity in other spaces. You can by design create a portfolio that has a low correlation. For example, you take a long position on Australia, short position on New Zealand, on the currency, we cannot guarantee to make money with that, but the returns generated by that sort of strategy almost certainly will have a low correlation to most other things investors will be doing.

And so, you have something that many investors are not utilizing enough. And so that is why we are offering mutual funds in that space to try to give investors another opportunity to find diversification in an environment that's increasingly difficult to find diversification in.

Papagiannis: So, you're talking about the currency markets, how they are not as volatile as the headlines make them out to be. Why is that?

Merk: Well, first of all, most folks in the currency market use leverage, but you don’t have to use leverage in the currency market. We don’t use leverage typically on any of our funds. And the reason why a currency move makes headlines is because it affects millions of people; it affects major economies when the euro or the yen moves by a cent. That affects the export capacity of a country. And so it's important, it's relevant.

But at the same time if you look at the journalist covering the space they tend to focus on the tick-by-tick data or what's happening in a day. At the same time it is quite possible to invest in currencies on the longer-term basis; that's what we focus on. Making a macro call that if a country spends and prints more money, well odds are that that currency may weaken over time. We happen to be more positive on a Eurozone than many people are, because in the Eurozone over €240 billion in liquidity was withdrawn in July. Austerity measures are implemented seriously. We think there is value to be had there. And they are taking care of the problems, whereas in the US we're not. And so you are able to make investment decisions based on longer term fundamental causes while in the currency market.

Papagiannis: In your fund, in your Hard Currency Fund, you're basically betting against the US dollar and for a diversified basket of foreign currencies. So, can you explain why you think that that might have a positive return over the next several years?

Merk: Sure. We have a managed basket of currencies. So we steer the money outside of the US dollar into the managed basket of currencies, and it's as simple as the belief that in the US it is easier to spend and print money than in other places in the world; add to that that we do not allow the market forces to adjust, that we are subsidizing a 2006-2007 environment, and that creates a very inefficient economy, and so we are not going to get the growth either.

Some people think you need to have economic growth to have a strong currency. That only applies when you have a current account deficit, when you need to attract money from abroad. The Japanese have had lousy economic growth for long time, but as long as they are not intervening their currency is rising, because people are saving more.

Similarly, in the Eurozone they are not spending and printing as much money. Ben Bernanke, head of Federal Reserve has said that going off the gold standard during the Great Depression has helped the US get out of the Great Depression faster. While that may be true, but the flip side of that is if you spend and print less money, then your growth maybe lagging, but you can have a strong currency.

We believe that this is going to be a very long-term trend, because we have massive fiscal deficit problems down in the pipeline, and so there is a very good risk that Congress is not going to suddenly come to an agreement on all of these issues and that inflation is going to be the path of least resistance--that is how many of these entitlement issues will be addressed.

And then similarly on the Federal Reserve, the best thing that can happen for the Federal Reserve right now is that we have slow economic growth. The worst would be high economic growth, because we don’t believe the Federal Reserve can mop up this liquidity. There is too much leverage in the US economy.

If they were actually to mop it up would crush right back down. That’s the last thing the Federal Reserve would want. And so the risks are, clearly in our view, could cause an inflationary path, maybe an inflationary growth path, maybe a stagflationary path. But those scenarios don’t bode well for the US dollar for years to come, and that’s why we believe diversification beyond the US dollar may be helpful.

Papagiannis: Currencies are considered an alternative asset class by some, and the hallmark of a good alternative investment is a positive risk-adjusted return and low correlation. So we talked about how investing in international currencies can have a low correlation, and then we talked about the positive return, and then we’re talking about how the volatility of the currency market is much lower than some people think, and also lower than in equities. So that bodes well for the positive risk-adjusted return. So, if I use currencies as an alternative in my portfolio, what kind of allocation would I give?

Merk: Sure. I’d like to add liquidity by the way as well. Many alternative assets, in times of crisis, many managers can’t execute their strategy. And the currency market in 2008, there was plenty of liquidity there.

Now, we believe that alternatives in this current environment should make a very large percentage of somebody’s portfolio, simply because traditional asset classes are too correlated and have their own set of challenges. And we can’t give specific advice on how big an allocation people should give to currencies, but we see some people give 5% to 15%, some of them consider gold as a currency and have that as part of that. But we are very comfortable with that metric. Now, personally being in that space, I have a substantially higher allocation, but obviously every investor has to choose for themselves.

We happen to believe that the risks posed by increasingly correlated assets is so great that one has to actively look for diversification; and then, of course, in the currency space, the risk-return profile is going to be very much tailored and every different type of products have different risk-return profiles. But I think people should look at that asset class very, very closely.