A new asset class for the new year

Improving returns With a market environment of low interest rates and low volatility in equity markets, many professional investors have been searching for new strategies to boost portfolio returns. The search for such sources of outperformance (alpha) is difficult as markets are generally considered to be reasonably efficient. One asset class where outperformance may be generated is currency, a very old asset class but new to many investors. In the past, many investors approached currency by simply accepting that their portfolios had a currency exposure that could go up or down relative to the base currency of their portfolios. More recently, sophisticated investors have opted for a passive approach, thereby minimising the potential for currency fluctuations to destroy alpha generated by their process. This approach, hedging, is purely mechanical and works by flattening the fluctuations caused by changing foreign exchange markets. Today, currency can also be used to potentially improve investors’ returns. By allowing currency fund managers to invest in the currency pairs they predict to be more likely to outperform, they can consequently generate alpha. Benefits include:

• Currency can provide significant potential returns due to the inefficiency of foreign exchange markets;
• It has a low correlation to traditional asset classes such as equities and bonds;
• It offers access to a broad range of different macro-economic opportunities due to the depth and liquidity of markets.

Currency markets are both highly liquid and inefficient – an ideal arena for active managers to exploit attractive investment opportunities at low cost. With around $1,900bn traded per day, the currency markets are the largest and most liquid markets in the world. This liquidity is generated from many different sources: multi-national companies trading goods, investors seeking international exposure to stocks and bonds, for example. Market participants make transactions in the currency market with different objectives in mind. These can create inefficiencies for active managers can exploit. For example, when central banks seek to influence exchange rates, their principal objective is macro-economic or political – rather than profit maximisation. Similarly, when a corporation hedges its overseas revenue, it is effectively buying insurance against unfavourable currency movements and not primarily transacting for profit. Even when the objective is motivated by profit maximisation, the price of the currency is rarely factored into the underlying investment decision. Often the price, or exchange rate, is simply accepted as it is. Diversification benefits In the context of an asset allocation framework, currency can help to diversify a portfolio. This is because long-term active currency returns are driven by a range of economic factors that differ from those driving equity and bonds returns. Currency tends to exhibit a low correlation with traditional investments. There are inherent diversification benefits which arise from allocating among different sources of risk with active currency management representing a further important diversifier. A currency allocation in any multi-asset class portfolio may potentially add a marginal contribution to returns greater than its overall contribution to portfolio risk.