A curious collision of geography, history and reading matter occurred on August 1. I was on the way to Bretton Woods in the mountains of New Hampshire reading the Financial Times. A report said that, after a poor 2005, many currency hedge funds were faring equally badly in 2006. It concluded: “A second year of losses could erode the post-Millennium consensus that currency is an asset class in its own right.”
The collapse of the Bretton Woods agreement in 1973 marked the end of fixed exchange rates. This, in turn, created the foreign exchange market as we know it. And what a mighty edifice it is. The Triennial Central Bank Survey of Foreign Exchange and Derivatives Market Activity, published by the Bank for International Settlements in 2004, recorded that the FX market trades $1.9 trillion a day.
That survey also noted the rising power of institutional investors in the FX world. Their turnover grew 78% in the three years between 2001 and 2004, to $585 billion. Unfortunately, as the pink ’un pointed out, this surge in investment has coincided with a period of lacklustre performance. The Parker FX Index, which measures the returns of 66 currency funds managed by 45 firms in North America and Europe that focus on FX as an asset class, rose by a limp 0.02% in 2005, after falling 0.61% in 2004.
This is the worst two-year performance in the 11-year history of the index. And 2006 isn’t exactly shaping up to be a shindig. Year to date, the index is flat. “A good portion of the index is made up of trend-following managers, and it has been a tough environment,” says Virginia Parker, chief investment officer of Parker Global Strategies. But reports of the death of FX as an asset class are surely exaggerated. The rationale that prompted investors to buy into FX and diversify away from the usual menu of equities and bonds remains compelling. It is supported by investment practice, theory and by the numbers.
Almost all of the alternative asset classes available to investors – private equity, real estate, commodities, timber, and infrastructure – are illiquid, priced infrequently, difficult to enter and tougher still to exit. The FX market is the most liquid in the world. The most actively traded stock in Europe, BP, has a turnover of about $400 million per day. The daily turnover of the Norwegian krone, which only just makes the top 10 of actively traded currencies, is about $10 billion. There is ample scope to invest, but do currency managers make money?
Finance 101 says that for there to be systematic winners in a closed investment universe, there have to be systematic losers. In equity and bond markets, it is hard to identify who the losers might be, unless you believe amateur, retail investors create opportunities for professionals. However, there is little to support this in the numbers, as, on average, professionally managed mutual funds do not beat the main indices.
FX, on the other hand, is replete with dumb money. Central banks do strange things in FX markets that are not motivated by generating returns. Corporations are more interested in hedging the risk of FX exposure than maximizing profits. Those few companies that have tried to run treasury as a profit centre have generally had their fingers badly burnt.
| G4 equally-weighted basket one-month implied (annualized) |
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| Source: State Street Global Markets |
But the biggest dumb bid of all is from other so-called investment professionals. Nine out of 10 international equity managers regard currencies rather as a sports fan views a ticket to the big match: they get you into the game but have no intrinsic value. If anything, they are an irritant, a hurdle to be overcome. Money has been pouring into these international equity managers.
This wall of dumb money ought to create opportunities for active, skilled currency traders. Over the longer term this arbitrage has been captured. A recent Deutsche Bank report* looked at the returns available to a hybrid FX portfolio that equally weighted three naïve investment strategies based on yield (carry), momentum and valuation.
This hypothetical portfolio produced annualized return of 12% from 1980 through to the end of 2005, with a Sharpe ratio of 0.92%, a result better than both global equities and bonds over the same time period. Best of all, the study showed that there was minimal correlation between currency returns and equities and negative correlation with bonds.
Currency as an asset class is here to stay. Recent economic data from Europe, Asia and the US suggest that the big economies are at very different stages of the economic cycle. The Federal Reserve has paused, which means the one-way bet on US rates has gone. A rise in FX volatility is on the cards, which should put the juice back into currency funds.
*Currencies: pensions saviour?, Bilal Hafeez
Andrew Capon is editor-in-chief at State Street Global Markets, the research and trading business of State Street Corp. He was formerly senior editor at Institutional Investor and has won numerous awards for journalism on fund management and investment issues.
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