During the financial crisis of 2008, institutional investors discovered to their horror that many of the assets in their portfolios were far more correlated than they had thought. Since then a search has been under way for an asset class that can provide consistent returns while remaining uncorrelated with equities and bonds. In a 2012 paper called “A New Look at Currency Investing,” Richard Levich, a finance professor at New York University’s Leonard N. Stern School of Business, and Momtchil Pojarliev, a senior foreign exchange portfolio manager at New York–based investment firm Fischer Francis Trees & Watts, made the case for using forex to diversify portfolios and lower the risk of equity investing.
“Foreign exchange risk is looked at as a toxic substance to be gotten rid of,” Levich says. “Pojarliev and I are saying just the opposite: that currency offers an opportunity for rates of return that would also enhance the risk-return profile of institutional investors. It’s an orphan asset class that is underutilized.”
The approach outlined by Levich and Pojarliev requires a new definition for the term “beta.” As originally conceived by economist Harry Markowitz, beta reflected how the overall market drives individual stock price returns. In a foreign exchange context, though, it’s come to mean the risk premium offered by three diverse currency strategies: carry trade, momentum and value investments.
Levich and Pojarliev found that combinations of these three strategies not only provided greater returns than the individual strategies themselves but also lowered the risk of equity investments in the portfolio. Several firms that specialize in forex have begun offering institutional clients strategies that embrace these beta investment ideas. For example, Seattle-based asset manager Russell Investments has a number of clients in Japan following a balanced strategy consisting of one third carry trades, one third momentum bets and one third value plays.
The carry trade strategy buys the three developed-world currencies whose countries have the highest interest rates by borrowing the three lowest-yielding currencies. The momentum strategy buys the three fastest-rising currencies and shorts the three fastest-falling ones. Value buys the three most undervalued currencies as measured by the Organization for Economic Cooperation and Development’s purchasing power parity index and sells the three most overvalued.
“It’s very simple, easy to replicate, and there’s no black box,” says Michael DuCharme, head of foreign exchange, business growth and development at $246 billion Russell. Between December 1999 and March 2013, the latest period studied, the portfolio returned 4 percent annually, he adds.
James Wood-Collins, CEO of Windsor, England–based Record Currency Management, which has $37 billion in assets, says about 5 percent of those funds are in managed accounts using one of the three strategies, plus some separate accounts that blend the three. Record also uses a fourth strategy, based on buying high-yielding emerging-markets currencies with low-yielding developed-world currencies. Unlike Russell, it doesn’t have a fixed formula for determining how much goes to each strategy in the blended approach.
“We have some ability to tilt,” Wood-Collins says. “For example, we might go overweight carry trade and emerging markets if we think it’s an environment where the risk premium will be rewarded.” Using Record’s blended strategy over the past 25 years would have produced annual returns of 2.5 percent with 3.5 percent volatility, Wood-Collins says. By adding leverage, he notes, the portfolio could produce even more attractive returns.
Consulting firm Towers Watson takes yet another approach. According to London-based senior investment consultant Matthew Roberts, it looks for anomalies in currency indexes and tries to improve returns, a process it calls smart beta. For example, Roberts explains, emerging-markets currency indexes tend to overweight Latin American currencies. Towers Watson has developed a proprietary emerging-markets index that rebalances the currencies included to weight Latin America equally with other regions.
Instead of just three currencies, Towers Watson uses 45 pairs of them in its carry trade strategy. Some are emerging-markets currencies that it buys while shorting developed-world counterparts. The firm maintains that its strategy can outperform indexes based on simple carry trades.
The research by NYU’s Levich and FFTW’s Pojarliev bears out this notion. Comparing three currency investment strategies, they found that a proprietary approach that deploys indexes and improves on them tends to outperform so-called naive strategies using only indexes. In a portfolio combined with the MSCI World Index, the proprietary beta forex strategy earned 206 basis points in excess returns, whereas the simple beta strategy earned only 46 basis points. Even more interesting, the managed portfolio had lower volatility than the index. • •
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