That said, as an asset class, currency is still very much in its infancy. It has been brought to the forefront in the last few years due to some significant moves in currency markets, particularly in the so-called commodity currencies – the Canadian, New Zealand and Australian dollars – where variation in double-digit percentages have been quite common.

Turbulence

Pension funds tend to approach currency from an overlay perspective, rather to reduce risk than solely enhancing portfolio returns. Turbulent equity markets, together with volatile exchange rates, have recently highlighted the extent to which currency movement can undermine returns on international portfolios. As an example, Canadian pension funds, which traditionally invest significantly in the US equity market, have seen their US equity return in 2003 being eroded away by the strong appreciation in the Canadian dollar versus the US dollar.
Funds with only a smaller proportion (say, 5 to 10 per cent) invested in overseas markets, have in the past found the currency effect less noticeable. In a down cycle, where equity returns are poor, the extra downside of currency movement becomes – and became – starkly obvious.
The solution for a pension fund, foundation or other institution is to hedge away the currency risk. They do this by employing a currency overlay strategy, which
sells forward the foreign currencies of the portfolio so as to insure against the dangers of foreign currency depreciation versus their local currency.
The same techniques that are used to overlay institutional portfolios can also be used within a context of currency as an asset class and may prove valuable for sophisticated high net worth individuals (HNWIs) in search of diversification.

Liquid currencies

Managing currency as an asset class involves buying or selling (underweighting or overweighting) currencies on FX markets so as to generate value. Some strategies restrict this to G10 currencies; others broaden the pool to include more “exotic” and also less liquid currencies.
Usually currency managers take a position across currencies by using forward contracts, with a maturity of up to (say) three months. Traditionally, asset managers have had investment process to deal with currencies that remained focused on fundamentals, therefore concentrating on a medium to long-term macro view of the market based on expected level of inflation, gross domestic product and also relative productivity concepts.
While these are certainly explanatory factors of FX markets, they usually address longer timescale, (six to 12 months) that may not always coincide with the time horizon of the average investor. Others such as ABN AMRO Asset Management Limited use a more quantitatively driven process relying on time series analysis, to address shorter time horizons.

Cutting costs

The investment process, principally a quantitative framework, incorporates trend factors, relative inflation expectations and interest rate differentials. Based on market prices, it can generate buy or sell recommendations in relation to 67 different exchange rates.
The allocation is then constructed so as to maximise diversification across currency strategies for a pre-defined level of risk. That is, if the risk target is 12 per cent, we will aim to use the maximum number of strategies possible without exceeding the risk target.
The process also focuses strongly on liquidity while constructing the portfolio allocation – essentially, keeping a higher proportion of the assets in more liquid currencies (such as the US dollar or the euro) and less in the less liquid ones (such as the New Zealand or Australian dollars), but without excluding the relatively illiquid currencies altogether.
The rationale is that as an example Antipodean dollars – and other relatively illiquid currencies – do not come cheap. While (say) buying euros could come with a spread of around 0.07 per cent, the costs of buying an illiquid currency such as the New Zealand dollar can work out to about 1.2 per cent for significant transaction size. This investment process aims to balance the costs of entering or exiting such illiquid markets against the benefits of diversification that these currencies may provide.
More generally, by using exactly the same approach for high net worth individuals’ assets than for currency overlay for institutional giants, trading costs can be cut across the board for HNWI clients. Using block trades means private individuals may benefit from the same mar- ket access as traders’ cherished institutional accounts.

Times of change

Although economic cycles in themselves – the headline bear or bull markets – do not have much impact on the decision making process of quantitively driven investment styles, generally speaking currency managers tend to do best in times of change. Changes in inflation and changes (or anticipated changes) in interest rate levels across the globe generate potential source of value for those who know how to access it. Active currency managers benefit from changes in relative productivity between countries.
Currency managers can generate returns in many market configurations and have not to rely solely on a bearish dollar trend; they may also add value when the US dollar appreciates or tap into other market opportunities such as cross currency trade or emerging market strategies. With most funds offering monthly liquidity and some offering bimonthly liquidity, currency strategies are also attractively accessible to the investor.
Currency funds are an alternative investment. They are by no means to be considered risk free, but the return relative to risk is attractive: information ratios (excess return/tracking error) over the medium term are generally in the range 0.5 to 1. Thus currency products compete well with other more traditional asset classes.
As highlighted by investment consultant research and also the many peer group benchmarks available, currency managers have outperformed through time and also more significantly over the last couple of years. In 2003, many currency managers had an information ratio (ie, return divided by risk) ranging between 1 and 2.

For whom?

Crucially, and on top of an already impressive CV, currency products offer diversification from the major asset classes. As the industry settles into the new millennium, with investors still disillusioned and fearful after the bursting of the technology bubble, it is one of the strong candidates for the investor to consider.
But for whom? Who should invest in FX? As an investment class, rather than a tactical overlay, it is very much the territory of the wealthy individual in search of alternative sources of alpha, rather than the institution. But this could change.
Institutions are investing increasingly in alternative investments. As pension funds battle to match liabilities with investments, allocation to absolute return products such as currency funds makes increasing sense.
However, sophisticated individuals have the edge in terms of asset allocation strategy: they have the advantage, in terms of speed, of not having to convince a board of fairly conservatively minded trustees.

Risk-profile

Clearly, a HNWI’s allocation to the asset class – indeed, his decision whether to go into it at all – will depend on his risk-aversion profile and liabilities. But currency management, whether through guaranteed notes or funds with frequent access, is attractive across different utility curves. A diversifying investor with a 10-year investment horizon might invest a portion of his assets in FX, but then so might a short-term thinker who wants to remove the money, plus benefit from potentially significant return over a short-term horizon. Both have been done.
Currency, with its significant risk-return credentials, is attractive as a stand-alone asset class. But it also has a real appeal as part of an HNWI’s allocation to alternative investments. It can fill a role similar to that played by hedge funds or private equity in a portfolio.
It is impossible to make any set rules, as individual risk profiles are so variable, but a reasonable allocation for a sophisticated HNWI could be 10 to 15 per cent to alternative investments. Within that, he could sensibly allocate 5 per cent of the total portfolio to currency.
That settled, he is free to get back to choosing between Thomas Cook and American Express at the airport, and planning his weekend in New York.
Pierre Lequeux, head of currency management, ABN AMRO Asset Management Limited

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