Currencies as an asset class

With the difficulties in the traditional asset classes over the last couple of years, more clients are turning to their overlay providers and asking whether currencies are a suitable asset class for alternative investments. The answer to this question is a resounding YES!
Currency overlay has become a well-established technique for adding incremental gains by increasing and decreasing currency hedges at the appropriate times. Hedge funds also have become ‘respectable’ investments this year. These two factors have driven the growth of currencies as an asset class.
The currency overlay world tends to be split into two camps – the return enhancers and the risk managers. It is natural for the return-enhancement overlay managers, such as our team, to apply their currency skill to achieving pure alpha. Additionally, there are a number of specialist hedge funds dealing only in currency. These funds tend to have a very well defined approach to the market gained from many years of experience. One such manager, Mel Mayne, partner of Ultimex Currency Managers, explains, “We are finding that currency asset class products are becoming increasingly popular within alternative investment portfolios.”
We have taken six publicly available currency fund track records and correlated their individual track records with traditional assets such as the S&P and the JP Morgan Global Bond Index. The results, shown in the table, illustrate that currency funds are not correlated with traditional assets. This meets the first requirement for alternative assets, lack of correlation.
The second requirement for alternative investments, of course, is to make money. Pension fund consultants’ research has found that currency overlay mandates in general do add value. As overlay managers can make money by good management of currency risk, then currency asset managers (often the same people using the same methodologies) can clearly make money in a currency fund.
One of the difficulties in measuring the return of currency funds is deciphering the maximum leverage used. This is the same question as asking how much capital needs to be allocated to a currency trade that has a forward value date and requires zero or minimal margin support. To try to answer this conundrum, we have displayed our model results as if a client had allocated £10m (E16m) to the programme in 1990. The currency trading would then be executed for a total face size of £10m, for value three months forward. Meanwhile the £10m is placed on three-month deposit. At the end of the three months, the fund now consists of the £10m, plus interest, plus the currency trading performance – but minus fees of course! This process is repeated, starting the next quarter with, say £10.2m. Thus these results are with compounded returns, but with no leverage at all. The chart contains a combination of simulated results for the early years and actual trading record for the most recent periods.
It can be seen that with no leverage, it is extremely unusual to experience a quarter where the total value of the fund does not increase. This is caused by interest being earned every period, adding to currency gains and masking any period with currency losses. Thus Sharpe ratios well over 1 are frequently achieved in the currency asset class world.
Currency asset class products are normally available as managed accounts or in a fund structure. Thus, depending on the clients’ preference, trading can be enacted in their name as most overlay accounts would operate, or alternatively as a fund where all of the day-to-day activity can be delegated.
As always, there is no short cut to manager selection. It remains a matter of understanding the thoroughness of the process and believing in the team behind it. Risk management strategies and return generation will naturally figure large in this research. Belief in the management team can be justified by their direct track record, and knowledge of their earlier career.
It is generally accepted that overlay managers are able to add value. Those overlay managers specifically targeting returns – as opposed to risk management – are already tasked with adding value in the currency arena. It is a very natural to ask those same managers to deliver absolute return from currencies.
Andy Winterton is head of currency overlay at Barclays Capital in London