By Noel Lamb
In some ways, trading currency to add value is part of a natural evolution of pension fund investing.
First — way back when — institutional investors concentrated only on bonds. Then they broadened their horizons and included domestic stocks in their portfolios. They followed this success by taking their first forays into international equities. The aim each time was to add value to their investments, to increase diversity and to reduce volatility. In the last decade, they have started turning to hedge funds, real estate and private equity as new vehicles to achieve those aims.
Now, facing low interest rates and forecasts of a lower equity premium in the years ahead, many are considering looking to more sources, including the currency markets.
Up to now many investors have resisted investing in currencies as it was viewed as a trading strategy and not as part of an asset allocation program. But increasingly, analysts are arguing that currency trading can be a way to diversify a portfolio. A number of investors are listening. In an environment where returns from traditional asset classes, such as stocks and bonds, do not have the same premium as in the 1990s, they are looking for untapped sources of outperformance, and currencies are seen as one of those.
Currency markets, which dwarf daily trading volume in the equity and bond markets, are both highly liquid and inefficient. They provide ideal ground, some say, for skilled managers to exploit attractive investment opportunities at low cost.
Currency movements depend on a number of factors, including interest rates, capital flows and a country's perceived economic strength. Geopolitical developments, actions by individual investors, trends in tourism and even government intervention also can affect currency movements. A skilled manager can exploit the differences, usually in a strategy based on fundamentals or one based on technical analysis.
Although far fewer currencies are available than stocks or bonds, portfolios that include as many as 30 currencies can be constructed to provide diversification. A number of managers with different investment styles also could be used in one fund to provide further diversification.
Investors can invest in currencies in at least two main ways. One would be as an overlay strategy that embraces part or all of a plan's assets. Such a strategy could be passive, in terms of which the overlay, by investing in currency forwards, would automatically hedge the fund back to the benchmark and so avoid currency risk. Or managers could adopt active hedging or overlay positions, believing short-run trends in exchange-rate movement and asset returns can be exploited to improve portfolio performance.
Another investment method would be to invest in currencies as part of an overall asset allocation strategy, along the lines of investing in stocks or bonds. A number of managers offer currency funds, although they are not yet regarded as mainstream investment vehicles.
The potential for adding value appears to be strong, at least judging by historical precedent. A study by Russell/Mellon CAPS analyzing data from 563 accounts supplied by 29 firms found that positive excess returns were achieved for 69% of active currency overlay accounts over the life of the account.
The study showed that positive excess returns were achieved for most active currency overlay accounts and managers. Positive information ratios also indicated an attractive risk/reward pattern for such accounts.
The growth in the number of managers and accounts indicates currency management is becoming a substantial opportunity for those wishing to pursue such a program as part of their overall investment strategies.
Noel Lamb is chief investment officer, North America, for Russell Investment Group in Tacoma, Wash.