UNKNOWN to many investors, most carry currency exposure in one sense or the other, either through foreign currency deposits or investments in foreign stock or bond markets. Only a minority of us, though, monitor or manage this exposure and its associated risks. Fewer still are investors who are aware of the investment opportunities that currency tools can offer.
The currency market is the world's largest, most efficient and liquid financial market. Daily trade volumes amount to US$1.9 trillion, based on a 2004 report by the Bank for International Settlement (BIS). Currency markets also operate almost ceaselessly as trading is set in motion from the start of Tokyo trading hours to when the sun sets on the New York Exchange. More than 85 per cent of currency transactions involve one of the six major currencies traded against the US dollar - euro, yen, pound, Canadian dollar, krona and the franc.
Being an accessible and liquid instrument, currencies have traditionally been used as a financial management tool for institutions to hedge away unwanted currency exposures. In recent years, however, institutions have started looking at currencies as an asset class in its own right.
Individual investors
Currencies are, in fact, fast becoming an asset class that individual investors should not ignore. Most of us are familiar with cash holdings or deposits denominated in foreign currencies. As an individual investor, you may be wondering whether there is a real need to diversify beyond traditional stock and bond investing and consider currency investments, which appear to carry high risks. Also, are there products investing in currencies which are suitable for you?
To be able to answer these questions, investors firstly need to recognise that the old adage of combining stocks and bonds to lower risk and enhance returns may no longer prove to be sufficient nor as effective as before in helping us diversify our long-term investments.
Under certain macroeconomic conditions, traditional stock/bond instruments have been shown to exhibit higher correlation with one another, that is, price movements moving in the same direction. Currency markets, which share weak correlations to stock and bond markets, can provide portfolios with diversified sources of return. In fact, currency markets may outperform regardless of falling or rising stock/bond markets.
A declining US dollar and lower investment returns expected from global stock and bond markets relative to the returns these markets generated within the last decade are also becoming compelling reasons why currencies may be needed to help generate additional returns for portfolios.
Passive and active strategies
How would currency work in your favour for your portfolio? Used correctly, currency investments offer the prospect of reduced volatility in an overall portfolio and enhance portfolio returns.
Increasingly, professional money managers advocate putting in place a combination of passive and active strategies, as well as actively managed tactical currency allocations, to either hedge existing currency exposures or to enhance returns within your portfolio.
Tactical asset allocation (TAA) is not a new concept in the investment world. Alternative, low or non-correlated assets have been widely used by institutional money managers and pension funds to add value to an existing portfolio of stock/bond assets, within set risk targets. Various TAA instruments used by institutions have also become familiar alternative investment tools for individual investors. These include hedge funds, commodity-linked investments, absolute return strategies, etc.
With currency rate movements tending to move little or even in opposite directions from stock and bond prices, it is no wonder that currencies are emerging as an important alternative asset tool for institutional players. Directional trends for currencies are also shorter in duration and can be captured using more opportunistic investments. These short-tenured instruments are attractive to institutions interested in gaining higher returns on some portions of their liquid assets.
As a retail investor today, you can also choose from an array of currency investment products, ranging from simple principal-protected, currency-linked structured deposits such as currency linked accounts that provide enhanced yields, to speculative dual currency investments, such as currency linked investments, which allow investors to profit from their views of currency movements.
Currency futures, FX margin trading and other currency derivative instruments may also be options from which you can choose to further diversify your portfolio and enhance its potential to generate returns under any market condition. There are also professionally managed currency funds, which employ a combination of these strategies to exploit the volatility of currency movements for significantly higher returns. Such strategies, however, often carry higher risks and may not be suitable for most investors.
Two-for-one deal
A lot of us may not realise that when we invest in global equities/bonds, we are, in fact, receiving a two-for-one deal. We not only invest in the performance of the stocks/bonds, we are also investing in the movements of currencies in which our underlying assets are denominated. The value of our global investments fluctuates when foreign currencies strengthen or weaken relative to the Singapore dollar. The impact may be significant as foreign currencies may fluctuate significantly due to macroeconomic or geopolitical reasons.
This is most evident in bond funds, where currency rate movements tend to contribute to a considerable percentage of overall returns. Some bond funds, particularly Asian or emerging market debt funds, do expect to profit from currency rate movements of which their underlying fixed income investments are denominated. In contrast, global bond managers, who seek to neutralise the currency impact on their fund performances, would manage their funds against hedged benchmarks and try to fully hedge currency risks in order to maintain a currency neutral portfolio.
Professional money managers have begun to advocate that managing currency exposures, whether passively or actively, should be a consideration if investors have exposures of 15 per cent or more of their portfolio invested in foreign currency denominated assets, that is, global stocks or bonds.
You may wonder what all this means for your investment portfolio. Some money managers have suggested that managing currency exposures, whether passively or actively, should be a consideration if investors have exposures of 15 per cent or more of their portfolio invested in foreign currency denominated assets, that is, global stocks/bonds.
In relation to your Singapore dollar-based investment portfolio, this could simply mean choosing funds where managers themselves already either partially or fully hedge their foreign currency exposures versus the Singapore dollar.
If you are already invested in a global bond fund, you may want to check if your fund manager passively hedges his currency risks or takes active currency positions for additional returns. If you own a portfolio that has allocations to Asian or emerging market debt funds, you will most certainly have had active currency management strategies employed on your behalf as managers of these funds usually take on positions on currency movements for added returns.
Investors can also choose to invest in asset allocation funds that employ currency overlay strategies, absolute return funds or managed futures to gain from currency movements. However, you will need to be aware that having active currency positions increases overall portfolio risks as active currency exposures add incremental risks to the portfolio.
For as much as the currency market may represent a hotbed of investment opportunities, like any other investment, currency investments carry a measure of risk. If leverage is used, these risks can be significantly heightened.
As more currency strategies and tools are made available to retail investors, you will need to keep in mind that while such alternative investment options may help insulate your portfolio from excessive volatility or help generate additional returns, they carry their own set of risks and cannot guarantee returns nor protect against market losses.
The writer is managing director, deposits, insurance & investment strategy, consumer banking group, DBS Bank.
