Why You Should Have Currency Management in Your Portfolio

The currency market is unique among investment markets in that most currency market participants transact for reasons other than to make money. International equity managers buy and sell currencies to facilitate transactions in stocks. Corporations buy and sell currencies to facilitate import and export transactions and to hedge out unwanted risks. Central banks transact in currencies to achieve policy objectives such as smoothing out unwanted fluctuations in exchange rates. These three large groups of market participants are all 'non-profit seekers' in the sense that they will tend to go ahead with their transactions regardless of whether or not they like the exchange rate on offer.

In a report produced by Deutsche Bank in 2007, they estimate that nearly three-quarters of currency market flows derive from these non-profit seekers. What is interesting is that all three of these large groups of participants in currency markets tend to lose money on their currency positions on average over time. As a result of this inefficiency within the currency market, alpha opportunities exist for skilled currency managers to add value to your existing investment portfolio. Advantages in currency management include:

Non-profit seeking participants. Minimal capital requirements. Low transaction costs. Deep and liquid market. 24/6 global market. US$2.9 trillion daily volume.

Not only does an investment opportunity exist in the currency market, but empirical evidence has suggested that active currency management generated positive risk-adjusted return over the long term. Investing directly in currency managers is the simplest way to access these currency market returns, as there is no need to develop your own currency expertise and trade your views. The Parker FX Index, which tracks the leading currency strategies around the globe, has increased 10-fold over the last two decades, while the Dow Jones increased only five-fold over the same period. Furthermore, the correlation between the Parker FX index and equity, commodity and bond indices is less than 10%.

Balancing Profit and Loss

International equity managers who are successful in making money for their clients by tilting their portfolios towards the best performing equity markets actually tend to give back around a percentage of the gains that they make on their equity market positions in the form of losses on the currency positions. The reason for this is that those countries with the best performing equity markets tend to have the weakest currencies and vice versa. This fact may not seem to make sense but just think about what happens to the share price of exporters whose currency is appreciating, it comes under pressure as investors expect their competitive position to be squeezed. Consequently, if a central bank suddenly reduces rates it is the equity market that receives a boost while its currency comes under immediate pressure. Therefore, to fully optimise your equity and bond portfolio, it is necessary to manage the currency risk.