The increasing participation of high-net-worth individuals is part of a wider trend that shows increased trading from non-financial institution participants in the FX markets. “The FX market has traditionally been an institutional market but since 2000 that has changed. Wealth managers, in particular, have traditionally not been active in currency investments,” says Sreekrishna Sankar, an analyst at consulting firm Celent and the author of a report: Retail FX: Entering a Phase of Mature Growth.
This is being driven by two factors in particular, says Sankar: declining returns in the equity markets and the inherent liquidity of the FX market, in particular its track record for staying open in times of crisis, when other markets have shut down. That has attracted retail investors, who now trade about $200 billion a day in the $4 trillion-a-day market. He estimates that high-net-worth investors make up as much as one-fifth of total retail volumes.
Nevertheless, it has been a difficult time for alternative investments generally: overall, allocations to alternative investments among high-net-worth individuals had declined 5% year on year to the end of 2010, according to the Capgemini Merrill Lynch 2011 World Wealth Report. However, allocations to some individual asset classes within alternatives have gone up, including FX. Commodities investments – including gold – have grown even more.
After consultations with the main wealth management firms, Celent estimates that FX holdings in high-net-worth individuals’ portfolios increased two percentage points to 10% in 2011. Their estimates are based only on direct FX holdings, that is, if the wealth manager allocates FX in a portfolio.
The figure is higher if FX holdings include indirect allocations to other funds by a wealth manager that might invest in FX, which makes Celent’s estimates conservative. According to estimates from the World Wealth Report, published by consulting group Capgemini and Merrill Lynch Wealth Management, foreign-currency holdings in high-net-worth investor portfolios increased by 2% to 15% in the year to the end of 2010.
The report explains that the increase was largely characterized by investment in the carry trade. This was especially pronounced in some regions, with Japanese high-net-worth investors allocating 34% to foreign currencies.
That shouldn’t be all that surprising given that Japanese investors have been active FX investors for longer than those in any other region, says Celent’s Sankar. He adds that even in the passive investor sector the number of investors is high, and they are again more active than their counterparts in Europe and the US.
When comparing the performance of equity with passive currency indices, equity investors are taking on much more risk for smaller returns, according to Sharpe ratios. For instance, the Dow Jones Industrial Average indicates an annualized return of just over 8%, while its measure of volatility is 16%. On an index made up of the Bric countries, which has a similar volatility, an investor yields a return of 17%. It is these dynamics that investors are only now beginning to understand fully, say index providers.
The World Wealth Report concluded that high-net-worth individuals’ allocations to commodities and foreign currency would continue to rise, underpinned by the demands of fast-developing economies, partly at the expense of hedge fund allocations, which are suffering amid regulatory concerns worldwide.
That said, growth of retail participation in FX is likely to be relatively restrained in coming years, says Sankar. Remaining growth is likely to come from Asia, with regulation hampering growth in the US and Europe. Of a retail FX market worth $200 billion a day, the US comprises 20%, Europe 30% and Asia 40%, the report showed.