Equities have a claim on dividends and retained profits, while fixed income has a claim on a stream of interest rate payments. As a result, these securities have long-term returns that can be anticipated, even though returns are not always positive over shorter periods of time. But is currency an asset class?
Many investors believe currency has no expected return. Currency has no claim to any income stream nor does a currency’s value reflect the underlying wealth of a nation. Does that mean currency should not be served up on the “smorgasbord” of investments investors should consider? Not at all!
Whether currency is an asset class or not, currency has emerged as one of the most important issues global investor must deal with. At a currency risk management conference organised in New York in 1998 by the Association for Investment Management and Research (AIMR), the proceedings were summed up in one sentence, “Superior performance of global portfolios requires effective management of currency risk.”
Equity and fixed income returns were significantly above their long-term averages in 1980–2000. Those exceptionally high returns made investing in currency less interesting, except in the form of leveraged “commodity” funds with risks and high management fees that made them unattractive to most institutional investors. That landscape has changed.
Although leveraged currency funds will remain available to investors who wish to add spice to their returns, the focus of making money from currencies will be on managing exposures associated with existing cross-border investments in stocks and fixed income.
Equity returns are not likely to be spectacular in the decade ahead. The likely reversion to the long-term mean of about 10% implies a difficult environment. And, the secular decline in interest rates, which began in 1981, may have ended. If so, the secular phase of capital gains reaped “automatically” as bond yields declined from 15% to 5% is over (Figure 1). In the new investment environment, institutional investors will have to employ supplemental strategies that can enhance portfolio returns with little additional risk. Currency exposure management is one of those strategies.
It is a myth that currency has no expected return. As documented in “Reality versus theory” (IPE September 1999), the Deutschmark rose an average of 3.5% a year against the dollar in 1969–98 while the yen rose about 5% a year. These gains are explained by relative inflation rates. A currency represents purchasing power, which inflation erodes. Different relative rates of inflation among nations cause some currencies to rise against other currencies over the long-term. Countries with institutional and cultural arrangements favoring low inflation have strong currencies. In Latin America, Africa and Asia these arrangements are largely lacking. Inflation is high and their currencies have long histories of depreciation that investors expect to continue.
However, it is not the underlying long-term appreciation or depreciation of currencies that form the basis for making money from currencies, but their large cyclical and annual price movements (Figure 2). Until recently, there was little evidence that investment managers could exploit these trends to manage currencies profitably. But the evidence has been gathered and the verdict is in. Pension fund consultants Frank Russell Company and Watson Wyatt Investment Consulting have made in-depth studies of currency overlay managers and their returns.
The results of Frank Russell’s study, Capturing alpha through active currency overlay were reviewed in “Overlays well worth the effort” (IPE September 2000). The Russell study found that the average overlay manager had produced an average annual excess return of 1.06% above the benchmark over 10 years. A total of 241 accounts with $85bn were examined. Accounts with five-year records ending in June 1999 had an average added value of 1.39% a year.

In the 1990s, when equities returned over 10% a year, extra returns of 100–150 basis points ayear were not that appetising. But in an environment in which returns are likely to average less than the historical 10% (inclusive of reinvested dividends) the added value a currency overlay programme can generate becomes much more mouth-watering.
In fact, Brian Hersey and Kurtlay Ogunc at Watson Wyatt have suggested currency overlay can be used to enhance returns even when an investment portfolio does not have underlying foreign investments that give rise to currency exposures. That view is a radical departure from the thinking of 10 years ago when currency overlay was born. In “Designing portable alpha engines” (IPE October 2000), Hersey and Ogunc concluded, “If one is looking for a specialised niche to boost returns over policy benchmarks, the currency overlay area promises to be the next undiscovered yet full of potential layer in the institutional portfolios.”
Hersey and Ogunc added: “It has become evident only within the last several years to convince plan sponsors of the value-added properties of currency overlay management programme due to the obvious inefficiencies in currency markets via different objectives and skill levels of participants. The currency overlay product is the active and independent management of the foreign exchange exposures associated with international investments by specialists… An active currency overlay programme minimises the probability of short-term losses due to a passive mandate that would be hard to recoup for investors with five to seven-year investment horizons.”
Although the results of the Frank Russell and Watson Wyatt studies demonstrate that overlay managers can add substantial value, most plan sponsor are unaware of the impressive returns they have produced. Even though it is estimated that over $100bn is now managed by about two dozen overlay management specialists, such as Pareto Partners, JP Morgan, Bridgewater Associates, Record Treasury Management and rapidly growing specialists like A G Bisset & Company and newcomer Lee Overlay Partners, most pension funds are unaware of their skills.
Last April, William M Mercer, a pension consultant, surveyed 566 of the largest pension funds in Australia, Canada, Japan, the UK and US. They were asked if their better active international equity, fixed income and currency overlay managers were “able to enhance their returns and/or reduce risk over the long term through active currency management”.
A total of 111 plans responded. Only 12% of them thought their better equity managers could add value while 44% thought they could not. The verdict was split for fixed income managers; 22% thought they added value while 22% thought they did not. One fifth, or 20%, of the plans agreed that overlay managers could add return while only 10% thought they did not. However, 42% of them did not know if currency overlay managers increased returns.
Although currency overlay is coming of age and it is an idea whose time has come, overlay managers and pension fund consultants need to educate investors about the return-boosting benefits a currency programme can have. Interestingly, for pension funds that already have exposure to currency, the risk/reward profile is very attractive. By appointing a team of two or three currency managers with different decision styles, the currency risk is reduced. And, the potential for adding an extra return of 1.5% or more, on average, over a number of years may be realised.
Whether currency is an asset class or not is now an irrelevant issue. Leading pension funds are presently harvesting returns from having their existing currency exposures managed by teams of currency overlay specialists who have solid track records. As more and more pension plans become aware of the return-boosting benefits a currency overlay programme can provide, overlay will become a “must have” just as global investing has become a fixture of prudent risk diversification.
Alfred Bisset is president and Ulf Lindahl is chief investment officer at AG Bisset & Company in Connecticut