Should FX be a core asset class?

The currency market may be by far the biggest in the world in terms of volume and among the most liquid, but it remains relatively little used as a stand-alone investment class globally.

London-based Record Currency Management says FX investments should form a bigger part of portfolios, with forward rate bias (FRB) central to its proposal, and Deutsche Bank takes a similarly bullish view on currencies, particularly Asian units. There are also plenty of other firms with a similar outlook, such as Aberdeen Asset Management and Barclays Wealth.

In September, Record CM launched an FRB index in conjunction with index provider FTSE, the FTSE Currency FRB5 Index, which takes a different approach from other FRB benchmarks and reflects how the firm's view of FX has developed, says founder, chairman and chief executive Neil Record.

"In thinking about FRB as an engine of absolute return, it's dawned on us that it's probably easier and more accurate to describe FRB as a 'risk premium' -- more like beta than alpha," Record tells AsianInvestor during a recent visit to Asia. "For a manager to come clean with that is a relatively unusual strategy. It means us telling our clients: 'You know what I was charging you alpha fees for? We now think it's actually beta.' They say 'fine', but they want lower fees as a result."

The FRB5 index equally weights 10 pairs made up from five major currencies and is always long nominally high-interest-rate currencies and short low-interest-rate currencies. This creates returns rather like equity returns, but with low correlation to equities over 30 years and bond-like volatility, Record says.

The basic concept of the FTSE Currency FRB5 is that certain countries are characteristically deficit countries, constantly importing more than they export (such as the US) and some are surplus countries (such as Japan). And investors in deficit countries require a certain risk premium for investing in those markets, says Record; that is what the FRB seeks to represent. Surplus country investors will only voluntarily hold the currencies of deficit countries if they are paid a risk premium for doing so.

"We think the currency FRB is a fundamental asset, and the only other two are bonds and equities," he adds. "I know that's a big claim, but we wouldn't make it if we didn't think [the index] ticks a number of boxes that means it qualifies."

Following the launch of the FTSE Currency FRB5 Index, Record CM has been on a "rolling worldwide roadshow explaining the concepts behind the index and the methodology and merits of it", says James Wood-Collins, head of the client team. In Asia, the tour took in Tokyo, Sydney, Melbourne, Seoul, Hong Kong and Singapore, with the firm seeing close to 100 institutions in the space of two weeks, he adds.

Institutions in Japan and Australia showed a good degree of understanding -- perhaps even a higher existing appreciation of the opportunities on offer from FRB. That's to be expected, given that the traditionally lower-interest-rate yen and higher-yielding Australian dollar is one of the most common currency pairs used for carry trades.

"In Seoul, investors have less existing exploitation of the phenomenon but a good awareness of it," he says. "They were very interested to hear about it as a new and uncorrelated return source."

In each case, the argument that it provides a sustainable risk premium was new and very well received.

"We're not yet at the stage when people are investing in funds and committing mandates because we're trying to convince them of something new," says Wood-Collins. "And we're not saying we've got some whizzy hedge fund product idea that you should stick $5 million into and we'll double your money in n years. We're saying you should think differently about your strategic asset allocation."

This is, he says, a lot to ask, which is why he expects investors to think carefully before implementing the proposal.

In five years, Record CM wants to be able to point not only to increased inflows for its products, but also to a raft of managers that track the FTSE Currency FRB5 Index or use it as a benchmark, and to investment banks that launch certificates, exchange-traded notes and so on.

Moreover, the FRB5 index is intended to be the first of a series of currency indices. FTSE and Record will launch other FRB-exploiting indices, including those offering a broader selection of currencies, such as the Australian and New Zealand dollar, says Wood-Collins. The firm will also launch a series of emerging-market or growing-GDP indices, for example, that track the phenomenon of currency appreciation in emerging markets.

It may be a while before such benchmarks really gain traction. Other than in the UK, stand-alone, return-seeking currency mandates for institutions are relatively few and far between, and the idea of a stand-alone emerging-market currency mandate is a fairly new concept, says Wood-Collins.

Yet the fact remains that a "significant proportion" of returns -- typically 40% or so -- from emerging-market equity or bond strategies in the past 10-15 years have been down to currency appreciation, he says. This raises the question of whether investors might want to separate out local equity market appreciation from local-currency appreciation, notes Wood-Collins, which is something Record CM is starting to research, along with FTSE.

Record CM has no Asian clients at present, although it has had Hong Kong and Australian customers in the past, and has a lot of relationships in the region, having been around for over 25 years and also thanks to its partnership with FTSE. 

Deutsche Bank, meanwhile, has often argued that for global portfolios to benefit most from FX, allocations to currency should be in the order of 20-30%. The bank suggests it should be seen as a comparable asset class to bonds and equities, but hasn't, due in part to the absence of a widely followed benchmark and a lack of understanding of the return characteristics of FX.

Moreover, Deutsche Bank says it expects Asian FX to contribute a particularly large proportion of returns this year, as compared to Asian stocks. In 2009, foreign investors earned 64% in local equities, but just 3% in Asian FX, according to Deutsche Bank research published in late April. However, the bank believes 2010 will see Asian currencies generate at least half of the total return for dollar-based investors, with both Asian currencies and local stocks around 10% higher (both are up 3% year-to-date).  

Yet Deutsche says it continues to view Asian FX as a relatively superior investment on a stand-alone basis this year, for three reasons. First, Asian currencies are well placed to benefit from policy tightening and equity capital raising in 2010 -- both themes are problematic for stocks.

Second, the bank's ex-ante Sharpe ratio on a passive Asian FX basket is above one this year, but well below this for Asian stocks (Deutsche says the latter is three to four times more volatile than its Asian FX basket). (The Sharpe ratio is a way of measuring risk-adjusted performance; the higher the number, the more sufficient are returns for each unit of risk.)

Third, Asian currencies remain structurally cheap, while equities are now fair to slightly expensive, says the research. And, of the four occasions in the past decade where the positive correlation between Asian FX and equity returns fell sharply, says Deutsche, three of these occurred when Asian FX rallied while stocks fell or were range-bound.

There appear to be some very good reasons why investors should perhaps start to think about currencies in the same way as they would bonds or equities, then. But, as Neil Record says, it seems unlikely to happen any time soon.