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From Special Report: Currency War - February 2013

Currencies are a good portfolio diversifier

Currencies represent a good diversifier away from bonds and equities.

By Cherry Reynard | Published Feb 12, 2013 | comments

As equity markets have raced ahead in January, a diversification strategy may not be top of every investor’s list of priorities.

However, if the fiscal cliff negotiations do not go to plan, or the European crisis rears its head once again, investors may resume their hunt for non-correlated asset classes. Of these, currency funds are an increasingly popular option.

Currency markets remain one of the few places investors can make money in all environments simply because they trade relative rather than absolute value. A good manager should, in theory, be consistently on the right side of the trade. Of course, it also means that a bad currency manager won’t be rescued by bullish markets in the same way as a bad equity manager might.

Investec, Pictet, Insight and Schroders all have dedicated currency funds. There are also some hybrid currency and fixed interest funds, such as the Tideway Global Navigator fund. Some are generalist funds, trying to make money by taking long-term positions on different currencies, others may specialise in niche areas such as emerging markets. Some currency hedge funds use a quantitative approach, looking at chart analysis and a currency’s historic trading range and ‘real-world’ exchange rates, such as the price of a McDonald’s burger in different countries.

Performance, as might be expected, is varied. The top fund in the offshore ‘currency other’ sector is the UBS (LUX) Money Market fund, up 23 per cent in five years. Sanlam Global Liquidity is at the bottom, having lost 4.6 per cent in the same period. The FE risk scores vary between 50 and 70, compared with more than 100 for most UK All Companies funds.

Thanos Papasavvas, a strategist in the fixed income and currency team at Investec, says that currencies are driven by fundamentals – a country’s underlying interest rate, economic situation, trade balance and similar metrics – and valuations, whether a currency looks cheap or expensive: “The recent moves in the euro, for example, have not been about fundamentals, which remain poor, but it was driven higher because everyone was either underweight or short of the euro.”

He says under or overweight positions in the Investec funds are determined by relative value – Malaysia versus India, for example.

Henry Lancaster, senior investment analyst at Coutts, says that currency investors are particularly sensitive to interest rate differentials: “That said, investors must take into account all the economic and other news that might affect the long-term attraction of a currency as an investment destination. So markets pay particular attention to the economic and political stability that underpins a currency’s creditworthiness.

“The appetite for risk among investors is a key determinant of the net flows into currencies deemed ‘safe havens’, such as the US dollar and Swiss franc, compared with investment in higher growth potential areas, such as emerging economies.”

Mr Papasavvas argues currency investing can be profitable because currencies may trade away from their fair value for long periods of time. As such, active managers should be able to deliver good returns by exploiting these imbalances. However, whether they succeed in practice comes down to the skill of the manager.

Peter Doherty, manager of the Tideway Global Navigator fund, can invest in both fixed interest and currency, but his fund is currently skewed towards currency bets: “We are trying to diversify ourselves away from sterling, which had been supported by a safe haven flight out of the euro. We trade currencies on a 6-12 month view. We keep a portfolio of dollar and sterling bonds and then change the foreign exchange exposure using forwards. We find that you have to be patient with currencies, particularly if you are treating them as an investment theme.”

Mr Papasavvas steers clear of the big, yen versus dollar, headline-making trades, suggesting that everyone is usually trying to benefit at the same time and risk is better managed through a series of smaller, under-the-radar trades. However, anyone trading independently, rather than through funds, might find themselves limited to trading in the larger currency movements. These are currently being seen in the yen, but Mr Lancaster says the real area of interest in the past year has been the euro: “It is up 10 per cent from its lows in the middle of last year, reflecting a pricing out of extreme ‘tail risk’ for the eurozone by investors,” he says.

Currencies represent a good diversifier away from bonds and equities and can be used to take positions on changes in the prevailing macroeconomic situation. However, only a handful of currency funds have proved themselves as top performers for the longer term, so investors need to ensure they have confidence in the manager’s skill.

Cherry Reynard is a freelance journalist

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