The debate over whether currency is a stand-alone asset class — or a quick ticket to a loss — is understandably complicated. Between 2002 and 2007, currency exhibited low correlation with equity. As a result, the argument for currency as a stand-alone asset class — or at the very least an alternative asset class — was strong.
But after the sharp downward move in the Chinese equity market on February 27, 2007, currency investing was never the same. Overnight, the currencies that previously showed low correlation with equities began to show a strong positive correlation.
Over the years, alternative asset classes have been playing a larger role in portfolio design. The advantage of using alternative asset classes is that they tend to have low correlation with traditional asset classes, such as stocks and bonds.
But identifying the investments which fall into this category is not easy, and such is the case with currency.
For example, prior to 2007, the Australian dollar provided high returns and had low correlation with equities. Currently, the Australian dollar still has high returns, but is highly correlated with equities and also has higher volatility.
A role in portfolio design
Currency’s recent negative to positive correlation shift to equities has raised the question of its role in portfolio design.
On the one hand, there are those who argue that currency is either its own asset class or a subset of alternative asset class, giving it a place in modern portfolio theory.
In the other camp are the traditionalists who say currency has no inherent value, and as a result is not an asset class in the same way stocks and bonds are. They believe that implementing currency management is a negative-sum game.
“The typical player can expect a loss…hardly the makings of an asset class in any meaningful sense of the term,” says Michael Nairne, president of Toronto-based Tacita Capital.
C.J. Gavsie, managing director, Corporate and Institutional Foreign Exchange Sales, BMO Capital Markets in Toronto, disagrees with the traditionalists. He believes if it moves up and down independently, then it’s an asset class of its own.
Gavsie says that with foreign holdings in a portfolio, investors already have foreign exchange exposure. It’s how they trade on those foreign assets that makes foreign exchange its own asset class.
“Where I am suggesting foreign exchange becomes its own asset class is for the type of fund manager who says, ‘Now that I bought Japanese stock and the British bond, I have the foreign exchange exposure and I am going to actively trade on it.’”
Profiting from currency investing
As Gavsie’s example illustrates, creation of wealth can be derived from the tactical acquisitions based on the foreign exchange exposure in the portfolio. In this case, it’s the foreign asset the investor uses to manage the foreign exchange exposure from the British bond.
Subsequently, economic return from foreign exchange is generally harvested from interest rate and foreign exchange rate differentials.
One popular strategy that capitalizes on interest rate differentials is the carry trade. With this currency trading strategy, investors sell a currency with a lower interest rate to purchase another currency for the purpose of buying the local higher-yield financial investments such as the local T-bill or short-term bond.
In the Australian example, investors looking for yield were attracted to the higher interest rate of the Australian short-term fixed income investments, so to purchase it they sold off the lower-rate U.S. dollar. The difference between the two rates is the economic return.
Nairne takes issue with associating currency with the term “asset class.” He feels currency doesn’t qualify because its return is derived from trading activities, rather than an inherent value found based on economic activities.
“Go and buy a basket of currency and, without a strategy, your expected return is zero,” says Nairne. “But if I buy a piece of all the bonds issued in the world on a market-weighted basis, I get an economic return. If I get stock, I get the dividends. Can you tell me what I get if I buy currencies?”
He says the fundamental difference between currency and the traditional asset classes such as stocks and bonds is that currency is a zero-sum game.
“In stocks and bonds you have a positive expected return because underneath there’s real capital being deployed to create more goods and return. But absent some sort of trading strategy, [the expected return on currency] is zero. Asset classes shouldn’t have zero expected return,” Nairne says.
Moreover, he believes that currency investing is not for the weak of heart.
“Most people are going to end up net losers,” says Nairne. “The reason [currency trading] requires greater sophistication and a lot of leveraging is because it’s not what we would call a traditional asset class. [With] currency and stock, underneath they’re two different beasts in how you get a profit out of them.”
Foreign exchange: source of beta
David Watt, vice-president, Senior Fixed Income and Currency Strategist, RBC Capital Markets, Toronto, leans more towards the idea of currency being its own asset class. “It’s not a solid asset class in some ways. You don’t necessarily go out to buy currency to sit on it.”
But, he says, the same debate exists about real estate and commodities, though people are investing in these assets as alternatives to the traditional stocks and bonds.
He adds that by ignoring foreign exchange as an asset class, the investor is potentially giving up some beta return.
For Watt, the key part of the debate comes down to whether there are models to explain the asset’s movements. In the case of currency, he says, there are many.
“We certainly have some models [for currency]. We have the Bridge Power Parity, which is very long-term and tends to be driven by inflation differentials,” says Watt.
The forward rate model, the theory that currency associated with higher interest rates should depreciate, is another one that’s closely watched. However, many take issue with the fact the model does not mirror real life experience; currency associated with a higher interest rate tends to strengthen, not weaken.
Finally, with the recent creation of the Parker Global FX index, managing currency became easier with this benchmark in place.
But despite all these characteristics that Watt argues validate currency as an asset class, none is more compelling than its low correlation with equities that changed after February 27, 2007. Since then, the currency market has experienced increased volatility and its correlation with equities has increased and stayed elevated.
Gavsie says increased volatility isn’t bad news for the currency market. It actually creates more opportunities for reaping return from foreign exchange via risk-on/risk-off types of transactions.
These types of transactions are generally based on global investors’ appetites for risk as exhibited by the activities in the U.S. stock market.
On risk-on days, investors’ risk appetites are high, leading to a sell-off of U.S. assets to purchase foreign assets. As a result, the U.S. dollar drops while foreign currencies soar. The risk level fluctuates daily with changes in macro news. And it’s the sudden changes that investors can capitalize on with foreign exchange, says Gavsie.
On risk-off days, stock indices will come down and the U.S. dollar will get bid back up versus other currencies. Gavsie points to recent developments in Ireland as an example.
On the day the Irish government stepped up and announced to the world it would likely need a financial bail-out, there were large risk-on transactions and investors were buying euro and stocks. But the next day, the market questioned whether the Irish story was speculation, creating a subsequent risk-off day during which the euro suffered.
Though he acknowledges that currency derives its return from trading strategies, Gavsie does not believe this disqualifies it as an asset class.
“Someone would be foolish to believe that over a short period of time there’s not going to be volatility from foreign exchange in their portfolio,” says Gavsie. “Those who are trading foreign exchange as an asset class are capitalizing on it — [though] not all of them are successful.”