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Foreign Exchange

Jason Batt, Head of currency index products, complex risk trading, global foreign exchange, Deutsche Bank: Now is the time for investable FX indices

Investors are being won over by the argument that currencies provide systematic returns, writes Jason Batt of Deutsche Bank.

Lee Oliver, Euromoney’s FX correspondent, is taking a well-deserved summer break. While he enjoys the clean air of the Alps, The weeklyFiX is provided by guest writers from the industry. Our final contributor is Jason Batt, Head of currency index products, complex risk trading, global foreign exchange at Deutsche Bank. 
Currencies are the largest financial market in the world, and yet it has only been recently that an investable index market has been established. Over the past 12 months investment banks and index providers have launched a broad range of indices with uses from “market access”, such as making it simpler for non FX-specialists to invest in a specific currency region, to indices replicating a complicated investment strategy that previously would only otherwise have been accessible by investing directly in a hedge fund.
The demand for investable FX indices has been driven by a structural appetite for uncorrelated absolute returns and a tactical search for value. Why now? Apart from the obvious problems that pension funds are now facing, there are several reasons why investors are waking up to currency being a sustainable source of systematic returns, rather than just a tertiary risk or a hedge instrument. First, with the end of the fixed-exchange rate arrangement of Bretton Woods in 1973, and the more widespread adoption of capital-account convertibility for developed world currencies in the early 1980s, we have now had freely floating currencies for at least 20 years. This time period covers major dollar up trends and down trends, strong recovery phases and recessions, and numerous idiosyncratic events. Therefore it should be a sufficient time period over which to determine whether there are consistent sources of returns in the FX markets. Second, evidence of the positive FX returns can be supported by the increasingly long and diverse sets of track records of actual returns delivered by FX-only investment managers.* Another important factor has been the large amount of academic research and theory that justifies the existence of systematic returns in the FX market, and why these returns should persist.
At the same time as investors are being won over by the argument that currencies do provide systematic returns, there has been an increased search for portfolio diversification as markets around the globe have become more correlated in general. This is evidenced by an increase in allocations to more alternative investments by the investment community. While commodities, hedge funds and private equity are also good diversifying investments, they lack the liquidity and transparency of an index that uses FX as an underlying. 
There is also a tactical reason that in the current environment investors are increasingly willing to look at currency and this reason is a search for value. Over the past five or so years most markets have experienced a general decrease in their level of volatility, the equity market is no longer wholly perceived to be undervalued, yield curves in most major currencies are relatively flat and, until the past few months, credit spreads have been at record lows. These factors coupled with increased liquidity on the world’s asset markets and an increased level of sophistication by investors have all helped increase the acceptance of FX as an asset class.
The users of FX indices range from retail investors to multinational corporations, insurance companies, asset managers, pension funds and even hedge funds. Some still use them as hedge instruments, which is the use of FX that people are most familiar with, but increasingly they are being used to generate returns in their own right.
Investors use FX indices rather than investing themselves for exactly the same as for other asset markets where the development of index investing spurred growth in the wider industry.  Investable indices offer even a novice investor access to an entire asset class, with daily liquidity and transparent pricing at generally quite low costs, all in a single trade. What is more, investors do not need to worry about rolling their position or reinvesting their returns, nor do they do need any prior knowledge about which assets to invest – they effectively outsource the intellectual property to the index provider which has created an index to capture a certain type of return or employ a certain investment strategy on a systematic basis. The final twist is that indices enable investors to gain exposure with certain risk/return attributes that they could not achieve by making a direct investment. They allow investment without actually putting up any cash, hence it is possible to gain leverage, and investment can also be made via structured notes where, for example, the investor has unlimited upside potential via a bullet coupon linked to the index but is guaranteed to get 100% of their capital back at maturity.
Only time will tell whether the growth of this industry proves transient or whether this is the infancy of a market that will provide a lasting addition to the opportunity set of the global investor. Given the current combination of demand and innovation focused in such a deep, liquid market growth in this sector only looks set to accelerate.
* These include the Parker FX Index, Stark currency Trader Index, Barclays Currency Traders Index, Deutsche Bank FxSelect Indices, and Russell/Mellon
Jason Batt is Head of Currency Index Products, Complex Risk Trading, Global Foreign Exchange, Deutsche Bank

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