Can You Make Cash with Currency?

by Paul Ha and Carlos Marenco
J.P. Morgan Investment Analytics and Consulting
paul.ha@jpmorgan.com, carlos.e.marenco@jpmorgan.com

Pension plans, endowments, and foundations allocate a significant portion of their total portfolio to foreign assets in both developed and emerging markets. In a recent study of institutional investment strategies, the J.P. Morgan Investment Analytics and Consulting group found that U.S. investors, on average, have targeted a 20% allocation to international investments. This sizeable allocation, if left un-hedged, has benefited from the weakness in the U.S. Dollar over the last several years. For the most recent year, the gain on currency has helped bolster these international equity returns by an estimated 9.64% (see Exhibit 1). Even longer term, the currency gains as a proportion of the total international return has been significant.

Since the U.S. Dollar is currently near all-time lows, we are seeing an increasing number of U.S. institutional investors revising, or at a minimum, reviewing their currency strategy. In our opinion at this point in time, it is certainly possible that the U.S. Dollar will bounce back, and that a strengthening dollar could have an adverse effect on the returns of international investments.

Foreign exchange rate risk and security valuation risk are the two main types of investment risk associated with foreign investments. Security valuation risk in foreign positions is driven by a number of factors such as market, sector, industry and stock specific – similar to the risk associated with domestic investments. Foreign exchange rate risk is the risk associated with the ownership of foreign securities that are traded in a foreign currency. The FX risk is due to the implicit currency exposure when holding these foreign positions.

Traditionally, when dealing with currency risk, institutional investors have relied on three primary options: maintain currency exposure, passively manage foreign currency exposure, or actively manage foreign currency exposure. Recently, J.P. Morgan Investment Analytics and Consulting has seen more plan sponsors treat currency as a separate asset class in an alpha-seeking strategy.

In this article, we will make a case for active currency management through a pure currency alpha strategy. The argument for an alpha-seeking currency mandate is threefold. First, currency’s low correlation to other traditional asset classes makes it an ideal candidate for diversification. Secondly, an active currency manager can capitalize on the trending nature of the currency market. Lastly, there are inefficiencies in the currency market that present opportunities to capture profit.

Hedging Strategies

Some institutional investors may choose to leave their portfolios un-hedged. In this instance, the portfolio will experience the full impact of the appreciation and depreciation of the local currency. Although the currency returns over a long time horizon should approach zero, the portfolio may experience an increase in volatility due to exchange rate fluctuations.

Passive currency management is intended to reduce foreign currency exposure and risk, not necessarily to increase return. The sole purpose of a passive currency program is to eliminate, to a degree, the impact from currency fluctuations on the value of foreign investments. The degree to which the currency risk is eliminated is dictated by the level of the hedge ratio that is employed¹. A hedge ratio of 50%, for example, would indicate that half of the currency exposure has been eliminated.

The goal of an active currency strategy is to capture gains while reducing risk on international investments. This can be achieved by altering the hedge ratio of the currencies to be hedged. Depending on the guidelines and latitude provided by the plan sponsor, the currency manager may be able to take advantage of the movement and volatility in the foreign exchange market.

For example, if the currency managers have a view that the Euro will continue to appreciate relative to the U.S. Dollar, they could under-hedge the Euro (or leave it completely un-hedged) to capture the anticipated currency gain. Conversely, if the currency managers have a view that the Swiss Franc would depreciate relative to the U.S. Dollar, they could over-hedge (or completely hedge) the Swiss Franc to offset the impact of the falling Franc. By partially hedging, institutional investors can enhance their portfolio returns by actively managing their currency risk.

Alpha-Seeking Strategies

Unlike traditional hedging programs, currency alpha strategies are not constrained by the currency exposures of the portfolio. By managing currency as a separate asset class, plan sponsors can make a pure alpha play by using forward contracts and eliminating the need for any initial funding. In this context, the currency managers are expected to add alpha (i.e., increase the overall risk-adjusted returns of the portfolio).

Diversification

The asset allocation of a typical institutional investor may include domestic and foreign equity, fixed income, real estate, and commodities. In our opinion, institutional investors may be able to reduce the overall risk of the portfolio by incorporating an alpha currency program into an established asset allocation. The addition of an asset class that is lowly or negatively correlated to the other major asset classes is a way to reduce the volatility of the overall plan and thus improve its risk/return profile.

In Exhibit 2, it is evident that a currency allocation can help offset some of the volatility that a “traditional” portfolio may encounter. The currency markets, as measured by the U.S. Dollar Index (DXY), have a low to negative correlation to the stock, bond, real estate and commodity markets, making it an attractive portfolio diversifier.

Opportunities

The argument against active currency management is that the long-term investment in a currency of a developed country is essentially a zero-sum investment. The long-term expected returns of the major currencies are zero. During times of economic prosperity, the host nation’s currency will become stronger relative to other currencies. However, when the economic tides turn, it will eventually give back the previous gains.

Currencies typically will move according to the outlook of a country’s economic data, and exchange rates tend to gain directional momentum and trend. In the short term, there is an inherent volatility as with any other asset class. However, over a longer time horizon, the economic health of the host nation should keep the momentum moving in the same direction. Exchange rate trends do persist for some time, resulting in an opportunity for skilled active managers to exploit currency swings.

The currency market is the world’s largest and most liquid market, with an average daily turnover of $3.2 trillion USD³. The daily currency turnover is more than ten times that of all of the world’s equity markets combined⁴. The volume can be attributed to a number of factors, including the different type of market participants and the various objectives they have for currency exchange. Currency exchange is employed by central banks to implement monetary policy, by commercial banks to manage cash flow, and by institutional investors to hedge exposure and enhance return.

For example, many investment managers execute foreign exchange trades for the sole purpose of making funds available in the local trading currency to execute foreign stock or bond trades. A central bank’s motivation for being players in the currency market is to stabilize their domestic currency or stave off the forces of inflation. In fact, central banks may have to buy or sell currency at inopportune times to satisfy their primary goals. Corporations can have significant currency exposure from foreign operations, trading, or debt servicing obligations. Their greater interest lies in neutralizing their currency exposure rather than maximizing profits.

With any active management strategy, there should be an exploitable market inefficiency in order for the strategy to be successful. Usually, this inefficiency comes at the cost of liquidity. In the currency market, we find the rare case where both are available.

Conclusion

As institutional investors continue to increase their allocation to international investments, especially in the emerging markets, a clear currency mandate is becoming an increasingly important part of portfolio management. Based on the goals, requirements and restrictions of the plan, the plan sponsor should review the currency policy in place and determine the optimal strategy.

Leaving the portfolio completely un-hedged may leave the portfolio exposed to unwanted volatility. While a passive strategy will help neutralize the currency risk associated with foreign investments, on a long-term basis, a 100% hedge can only be right 50% of the time. Given the portfolio diversification effects, the exploitable opportunities present in the currency market, and the potential to increase the risk/reward profile of the overall portfolio, institutional investors may want to consider alpha-seeking strategies in order to cash on currency.