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“When foreign exchange is viewed as a separate unconstrained source of total returns, it should take a share in global portfolios, possibly comparable to those of bonds and equities” Bilal Hafeez, Deutsche Bank |
Deutsche Bank believes forex could help solve the global pension crisis.
In a research note entitled Currencies: pensions saviour? Hafeez says that although FX has often been viewed as an alternative asset class it should now be considered as comparable to bonds and equities. FX “has exhibited long-term systematic returns or ‘beta’, which are comparable, if not better, than both bonds and equities since 1980. It also has greater liquidity than both,” Hafeez writes. Hafeez also highlights an obvious problem: the investment horizon of pension funds is by nature long term but their performance is increasingly being monitored in the short term. “This implies,” he says, “that there is an increasing sensitivity to quarterly or annual fluctuations of returns. Therefore, it is no longer appropriate to talk only of how to increase future returns, it is also necessary to consider the likely fluctuations of these returns over shorter time horizons.”
Allocations
He continues: “One of the most potentially rewarding routes to achieve higher returns with lower volatility is to include more assets that can offer higher returns and diversification… Indeed, estimates of the actual asset allocation of pension funds suggest an allocation of 33% to bonds, 48% to equities and 15% to ‘other’, which may include commodities.”
Hafeez points out that a major problem with ‘other’ assets is that they do not have deep liquidity. “In that context, foreign exchange stands out. It has the greatest liquidity of all markets, a track record of positive excess returns and offers true diversification to bonds and equities. Indeed, our work suggests that when foreign exchange is viewed as a separate unconstrained source of total returns, rather than as a constrained secondary risk to manage, foreign exchange should take a share in global portfolios, possibly comparable to those of bonds and equities,” he says.
However, a problem that fund managers face is that there is no recognized benchmark index for FX as there is in other markets. Hafeez does not put it so bluntly, but it is true to say that fund managers, for whatever reason, do need to have benchmarks to hide behind.
No benchmark
Hafeez says: “Unfortunately, there is no widely followed benchmark for FX returns in the same vein as those in equity and bond markets. However, it will likely only be a matter of time before one does get established, given the duration of the current free-float period.”
After examining several strategies individually and in combination against a benchmark Deutsche constructed for its research, Hafeez found that its combined FX benchmark outperformed equities and bonds in terms of risk-adjusted and absolute returns over a 25- and 15-year period. Therefore, the need for its inclusion in pension funds would seem obvious.
The next stage would seem for fund managers to consider what percentage of their assets to invest in FX. Hafeez believes it should be greater than that invested in equities. “On balance it would appear that FX should feature fairly prominently in any global portfolio, with allocations in the order of 20% or above the concept of achieving positive long-term returns from investing FX is not purely a theoretical one, and can be achieved in practice,” he concludes.
Relations
John Normand, commodity, currency and fixed-income strategist at JPMorgan, agrees that it is likely that fund managers will invest more in FX. “The issues are related in that reducing pension shortfalls will probably require more long-term exposure to risky assets and real assets (private equity, linkers, commodities) and more tactical exposure to trading asset classes, such as foreign exchange,” he says.
However, are there enough suitable skilled FX managers available to handle the demand if pension funds do decide to take this decision. Normand feels there are. “With any tactical asset class such as FX, the frequent question is which approach works best – carry, growth divergence or technicals? Not all strategies work equally well in all market environments. Carry, for example, tends to perform poorly when rates are rising, and well when rates are falling or stable,” says Normand.
He concludes: “Strategies therefore have to be flexible, or they have to be diversified. FX fund managers are probably better able to do this than those in other asset classes, since so many themes can impact currencies. By contrast, bond and stocks are almost always cyclical and monetary policy stories.”
