The Case For Active Currency Management
Currencies are overlooked and can produce significant amounts of that return-enhancing force called “alpha.”
Our first consideration is that currency is the largest and most liquid asset class in the world, dwarfing the daily turnover of bond and stock markets. The reason is the explosion in cross-border trading since the onset of a flexible exchange rate regime in the early 1970s.
Given the sheer size and depth of liquidity, many would be tempted to conclude that currencies are very efficient in terms of pricing. Actually, they aren’t. Identifying the key participants in global currency markets show why. The majority are multinational corporations simply hedging the foreign exchange exposure of their revenues and costs in their international business activities. In other words, they are passive investors with no profit motive.
Conversely, those participants trying to actively manage and benefit from exchange rate fluctuations are a clear minority. The net result is an inefficiently priced market with persistent opportunities.
Secondly, currencies bring that increasingly elusive property to portfolios called “low correlation.” This is important in a progressively synchronized and interconnected financial system. The recent global financial crisis has underscored one of the limitations of modern portfolio theory: Correlations among different asset classes are not always stable.
During recent periods of market panics, the performance of many asset classes were much more highly correlated to equities than most had expected. Conversely, currencies had a very stable low correlation. During the period 2007-2009, every asset class correlation increased significantly relative to U.S. and global equities. The one exception was currency returns.
Factors Driving Currency Returns
So the case for active currency management is strong based on inefficiency and low correlation. But how best to make active decisions?
To be sure, currency analysis is a tricky business. Currency moves, once they begin, rarely proceed as policymakers intend. Often, countries lose control of their currency. Other times, currency adjustments produce unintended effects in unexpected places.