Foreign Exchange: An Asset Class in Its Own Right?

by: Luca Avellini

Is foreign exchange an asset class in its own right? This question is certainly not new, yet it hasn’t been answered once and for all.

One of the reasons why FX, or forex, or currency trading (whatever we want to call it), is difficult to categorize is because of the lack of an appropriate benchmark.

When we evaluate the performance of an equity fund, the first piece of information we see is the comparison of its returns with the ones of the S&P, MSCI, or whatever index may be relevant. (This may or may not make sense, since it tends to make a program look good when it loses “only” 20% vis-à-vis a drop in the S&P of 30%: The reality is still that the fund lost money in absolute terms and at the end of the day, that’s all it matters. But this is another story.)

FX programs, on the other hand, don’t have an equivalent point of reference.

There are two types and fundamentally different approaches to currency trading: Overlay and Alpha. A currency overlay program is not targeting absolute returns, but rather it manages the exposure of other assets to currency risk. These assets, not the currencies, are the ones expected to generate a return.

The second type is an Alpha program. Here the manager must produce absolute returns. But then, one may ask, how can you separate the good and the bad? Good question! Not only do currency programs operate in absence of a recognized benchmark, they can also have individually customized volatility targets. This makes all comparisons very ambivalent.

So, let’s try to change the question to: is investing in a currency programs a viable, meaningful form of diversification?

The answer is twofold. Yes, because it is possible to allocate to multiple strategies with very low correlation among them; and yes, because currency programs show low correlation to other asset classes when investors need it most, i.e. in times of turbulence.

To demonstrate this, we looked at the universe of currency managers available on the Deutsche Bank Select platform. DB Select is a sort of marketplace where qualified investors can buy and sell a given currency program in a way not very different from placing a trade to buy a stock with a broker.

Without getting into too many details about the computation, let’s simply say that the results take into account the survivorship bias and each manager received an equal weight.

The first observation is based on the distribution of correlations among different currency/manager programs. Figure 1 contains two important elements:

  1. Correlation is symmetrically dispersed around the mean (no significant skew). This means that within the currency manager universe there are both programs highly correlated among each other, as well as programs that are totally uncorrelated. In other words it is possible, within the currency market, to create a basket of highly diversified solutions.
  2. The mean of the distribution is 3.2%. This suggests that on average currency managers run programs that show very low correlation.

Fig 1 (click to enlarge images):

Distribution of correlation among currency managers

The second point pertains to how currency programs can complement a traditional portfolio.

Again, we use a graph to visually capture the advantages.

Figure 2 shows the behavior of an index comprising of all currency managers on the Select Platform (equally weighted, compensated for survivorship bias) and the MSCI stock index for the period December 2006 – April 2011.

Fig 2:

MSCI and FX Managers 2006-2011

Figure 3 shows the same currency index and the S&P500 during the days surrounding the flash crash of May 2010.

Fig 3:

Flash Crash

Figure 4 shows a basket of nine international stock indices, and compares it to the S&P 500 over the period 2008-2009. For the record, the indices are: Nikkei 225, Hang Seng, Eurotop100, Nasdaq 100, Russell 2000, Dow Jones Industrials, Australia All Ordinaries, Emerging Market Index ETF (NYSEARCA:EEM), China 25 ETF (NYSEARCA:FXI)

Fig 4:

S&P vs Basket

A glance at the above graph makes go up in smoke all illusions of diversification simply via global allocation. At least when things get tough.

Finally, one last note to bring into the conversation the other traditional asset class: Bonds. It is widespread belief that bond funds offer proper diversification from equity portfolios. That is true, but only in part.

Figure 5 shows the behavior of an index built by equally weighting the ten largest US bond funds, and compares it to the S&P 500 index over the period 2008-09.

Diversification? Yes. Absolute returns? No.

Fig 5:


This brief note doesn’t have the ambition of revolutionizing any portfolio theories or approach to investing. Its only purpose is to trigger a dialogue among informed investors. This may then bring to the surface the advantages of including currencies, a relatively new asset class, to complement the so far unchallenged duopoly of equity and bonds. And this, in view of increased market volatility could be a very good idea indeed.

So, the next question is: how can we take advantage of the qualities of this asset class?

Up until less than ten years ago, it would have been very difficult for individual investors to have access to competitive pricing. That has changed dramatically with the introduction of electronic trading. There are three ways to enter the currency market:

The first way is through a wide variety of currency ETFs. All major currencies, such as the euro, the yen, the British pound, the Canadian dollars and so on, have a tradable ETF. They keep adding more, but this is a good starting list of what’s available with the symbol:

The second way to access the currency market, is through spot transactions. These are over the counter products, which means they don’t trade on any exchange. When you trade spot, your counterpart in not the CBOE, or the NYSE, or the Nasdaq: your counterpart is the broker through which you trade. This is important to keep in mind in times like 2008 when some of them became insolvent.

The third way is to trade futures. These, like ETFs and unlike spot, are listed on exchange and your trade with the exchange itself. However, futures are derivative products with a particularly high level of leverage. Thus, they are not for everybody. These are some of the futures available on the CME, with their symbol:

You can find the full list on the CME website.

So let’s say you think the euro is going to go up against the US dollar. You can buy the euro ETF (NYSEARCA:FXE). Or, you can open an account with one of the brokers, buy EUR vs. US dollars spot, and hold the position until you either made your profit or changed your view. Of course, you can achieve a very similar result by using the equivalent future.

Or let’s say you hold an equity fund invested mostly in Japanese yen, but you don’t like to be exposed to the exchange rate fluctuation. Well, you may consider selling Japanese yens against the US dollar (if the US dollar is your currency of choice). This would be a way to lock in the current exchange rate.

I encourage those of you who are interested, to further investigate this very interesting asset class. Several aspects of currencies are different from the equity markets many are accustomed to. For one, the leverage is higher. Then you need to remember that when you trade the forex market, you are always exchanging one currency for another. There are no trades in isolation. This is a topic worth discussing in more details, if anyone is interested.

Disclosure: I am partner in a funds of hedge funds that invests exclusively in currency programs.