Special Drawing Rights

SDR is an international reserve asset, created by the IMF in 1969 to supplement the existing official reserves of member countries

Diversification: prepackaged versus customized portfolios

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While some investors with the objective of improving expected returns may prefer to adopt a more active strategy of switching among their investments’ currency denominations, the stated objectives of most investors oriented towards the long term might be a conservative strategy of preserving the stability of their investment returns. For such investors, including reserve managers and many institutional investors, the use of a prepackaged diversifying instrument such as an SDR would have an added advantage of convenience and low cost.

 

As Dammers and McCauley (2006) note, the ready-made diversification through prepackaged portfolios could also prove advantageous to retail investors. Otherwise, for such investors, reasonable diversification would require both higher committed capital and buying a number of single-currency denominated instruments. A counterargument against prepackaged portfolios as risk diversifiers is that in the set of potential portfolios of the constituent currencies that can be constructed, the ready-made portfolio (in this case, the SDR weights) may not represent the absolute minimum risk portfolio. It may as well be argued that if investors prefer to hold a portfolio of currencies as a hedge, they could customize one to their unique needs, reflecting their desired currency composition and unique constraints.

 

With active currency markets, this can be accomplished through periodically rebalancing the hedge portfolio to tailor it to the desired investment objective. It might be true that the SDR portfolio may not constitute the minimum variance portfolio even within the universe of current SDR constituent currencies, let alone within a larger set of currencies in which an investor may have interest. Nonetheless, despite the relative efficiency loss from the SDR basket, there are a number of practical advantages to a strategy of using the prepackaged SDR.

 

First, customizing involves large transaction costs from the continuous rebalancing needed. Depending on the set of currencies in the customized portfolio and the degree of how active the investment strategy is, there could be substantial transaction costs incurred when moving away from a prepackaged portfolio denominated in the SDR to the customized one; such costs might not justify the potential efficiency gain. Moreover, the constituent currencies that denominate the SDR represent an overwhelmingly large amount of total global trade and investment transactions.