The currency market has exploded in terms of growth, since the shift to the flexible exchange rate system in the early 1970s. The primary reason is increasing globalization of the economy that has led to rapid growth in cross-border trading. The growth in international trade as a percent of global GDP has mirrored the increasing level of GDP itself. By 2007, nearly one-third of global GDP was generated through international trade. To contrast relative market size by average daily turnover, the global currency market, at $3.1 trillion, dwarfs the daily turnover in the major bond markets ($905 billion) and stock markets (approximately $322 billion) around the globe.
The forex currency exchange market is the largest in the world with significant amount of liquidity and robust trading volumes. However investors have limited exposure to currencies as an asset class due to the highly leveraged futures market nature or in institution-only over-the-counter arrangements. Unlike equity and bonds, currency market remains a relative mystery with a huge knowledge gap on its tactical importance amongst prospective investors. Despite its huge size, limited research is available on the strategic role that currency allocation can have. Traditionally its use has been limited to hedge a portfolio's base currency exposure. Currency offers the following benefits the following benefits and warrants an addition to ones portfolio.
1. Currency markets are liquid with relatively low transaction costs even in times of financial crisis and turmoil when other asset markets can demonstrate a severe shortage of buyers or liquidity providers.
Daily Volume of Currency Markets vs. Bond and Equity Markets 2010 (US$ bn)
Daily Volume of Currency Markets vs. other equity exchanges (US$ bn)
2. Amount of daily turnover in currency market is huge volumes and active currency management strategy can hardly run into capacity constraints. Currency trading is projected to have risen to a record $5 trillion a day in September 2011, surpassing the peak reached before Lehman Brothers collapse in 2008, according to the Bank for International Settlements.
3. Currency alpha is easily portable, as investors can add an active currency overlay to any type of portfolio.
4. Currency markets returns have historically had very low correlation to those of other asset classes and make perfect sense in the context of an overall asset allocation framework.
5. Unlike fixed income instruments, currencies do not have duration risk
The case for emerging market currency ETF
Globalization has led to U.S. dominance over the global economy decrease and the global capital markets system is becoming a thing of the past. In recent years, emerging market growth has outstripped the developed markets3. In the '80s, GDP growth in the developed and in the emerging worlds was essentially the same. But between 2000 and 2010, average growth in the emerging world rose to the point where it was three times higher, driven largely by the Asian economies.
Source: IMF & Black Rock
Moreover, as emerging economies have grown, the output of developed economies has been shrinking-a situation that is almost entirely explained by growth in Asia. The IMF data expressed asserts that from 1992 to 2015, advanced countries are expected to decline by 17% of total GDP-an unprecedented rate of deterioration. Developing Asia accounts for most of this drop, with growth expected to be 18% within the same time frame. The rest of the emerging world's weight in the world economy will remain roughly constant.
Source: IMF & Black Rock
Consider, for instance, that over the past 5 years, the U.S. share of total global market capitalization has fallen from an average of 36 percent in 2005 to 29 percent currently.
Much of this weight has swung to the so-called BRIC countries - Brazil, Russia, India and China - which now account for 7.6 percent of world market cap, putting this foursome on almost equal footing with the might of France and Germany combined. Many economists expect this trend to continue.
Moreover, as developing markets are seeing their sovereign debt subject to downgrade after downgrade, emerging markets are being quietly upgraded. It is one of the clearest signs of a convergence between emerging and developed markets as global economic power shifts.
There is a shift in macro fundamentals from developed to emerging countries. As a result of those trends, the U.S. share of the world's capital markets seem poised to continue shrinking. What this means for investors is that currency appears likely to play an ever more important role in their total portfolios and it will undoubtedly influence the returns of their equity and bond investments. Emerging market fundamentals remain excellent. Relative to developed markets, emerging market countries have lower levels of indebtedness and more robust levels of economic activity.Corporate profitability continues to be at premium levels compared with the developed markets, as has been the case for over a decade.
One can take exposure to the emerging market currencies using the ETFs. There are numerous options available with single currency funds and those like WisdomTree Dreyfus Emerging Currency Fund (NYSEARCA:CEW) which invest in a bouquet of currencies. Investors bullish about the entire emerging market spectrum can seek exposure by investing in CEW.
WisdomTree Dreyfus Emerging Currency Fund Overview is an actively managed exchange-traded fund that seeks to provide the investor with a liquid, broad-based exposure to money market rates and currency movements within emerging market countries. Although the Fund invests in very short-term instruments, the Fund is not a money market fund, and it is not the objective to maintain a constant share price.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.