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3 CyCompelling' Reasons to Add Currencies to Portfolios: Merk.

Byline: Janet Levaux

Advisors and investors are keen to minimize the impact of geopolitical risks, distressed commodities markets and other factors on their portfolios -- while improving returns, as well. This is driving many of them to take a deeper look at diversification and alternatives.

Can actively managed currencies help boost results?

That's what Axel Merk and his colleague Daniel Lucas of Merk Investments analyzed recently in white paper released on Tuesday.

"Our findings suggest that actively managed currency strategies can significantly reduce volatility and minimize drawdowns in portfolios, and that viewing risk dynamics as a trading signal can generate consistent alpha over time," they explained. The devil -- of course -- is in the details, which they explain through detailed analysis.

Currency Correlations

The argument for currencies "is quite compelling," they point out, since currencies have shown low correlation with other major asset classes in the medium- to long-term.

Plus, the correlation of currencies also has been comparatively stable.

"The same cannot be said for other popular alternative assets, such as real estate, which shows a relatively stable but high correlation with equities, or commodities that have a low correlation but especially in times of higher financial turmoil appears to be unstable," Merk and Lucas explained.

The low correlation to traditional asset classes, thus, make currencies "particularly qualified from a portfolio design perspective, and especially if we refer to a managed basket of currencies that follows a specific strategy with a non-zero expected return (such as well-known systematic strategies like carry, momentum or valuation), the inclusion of currencies as asset class is justifiable," the add.

In their analysis, the portfolio specialists at Merk used Deutsche Bank's Currency Return Index (DBCR), an equally weighted index of three common rule-based currency styles (carry, momentum and valuation) as a benchmark.

The foreign exchange market is "by far the most liquid market in the world, with more than $5.3 trillion in daily turnover worldwide," the authors note, and this means it is considered highly efficient. But research show, the particular microstructure of the foreign-exchange market "actually suggests that currency markets are not efficient in the classical sense."

Many large investors, like multinational corporations, central banks and government institutions, use foreign exchange for cash management purposes or currency hedging, rather than for making profits.

This provides a source of alpha for the active participant, Merk and Lucas explain. They add that profit-seeking active investors can thus potentially exploit the market's short to medium-term market inefficiencies.

New Research

The Merk team looks at how to best generate excess returns from currencies by targeting dynamics in risk sentiment, which are tied to perceptions of changing market conditions, in the FX market.

They notice that over a 10-year span, both passive currency and active currency approaches, as well as managed futures, seem to be largely uncorrelated with a 50/50 base portfolio. (In addition, real estate, hedge funds, private equity and to some degree commodities show higher average correlations, the study finds).

With back testing and other analysis, the researchers conclude that only active currency and real estate as partial allocation "were able to enhance returns of the portfolio."

As for reducing annualized volatility, the only alternative asset class allocations that did so were currencies (both active and passive), hedge funds and managed futures. But again, only active currency and managed futures "lead to a meaningful increase in the risk-adjusted return of the portfolio," the authors stated.

Passive currency allocation results in a reduction of the portfolio standard deviation, but at the expense of a reduced return, the report adds. "This makes the obvious case for active versus passive currency management in multi-asset allocations, i.e. the ability to provide an uncorrelated return stream to the portfolio that harvests alpha in the long run," wrote Merk and Lucas.

Furthermore, the research demonstrates that currencies "have attractive characteristics in the portfolio-design context, and that there is potential value, both conceptually and empirically, in considering actively managed currencies as opposed to prevalent market indices," they state.

Conclusions

The foreign-exchange market's large size and low trading costs mean advisors and investors have room to employ "highly scalable strategies," according the Merk report. "This is particularly relevant during periods of extreme market conditions, when execution generally becomes less efficient and execution risk in the FX market remains relatively low particularly for G10 currency forward transactions."

During these periods, correlations generally moving closer across asset classes, but currencies tend to remain relatively uncorrelated, they add.

Merk and Lucas offer three influential reasons to act on their research.

First, they argue, managed currencies should be considered an asset class "for the same reason that other popular alternative assets are.

In addition, since correlations of currencies with traditional investments are more favorable, showing lower and more stable correlations with equities, their research "suggests, partial allocation to managed currencies in multi-asset portfolios is especially effective in mitigating downside volatility and maximum drawdown."

In other words, advisors and investors who want to protect portfolio need to "broaden their horizon and be mindful of the powerful diversifying effect that currencies can have," according to the Merk researchers.

Second, it's worth looking at the benefits of participating in an inefficient market in which the majority of investors (MNCs, for instance) do not expect to maximize their returns.

Such inefficiencies give active market participants the chance to generate excess returns "by providing liquidity, oftentimes more pronounced during turbulent markets, when multi-asset portfolios are especially at risk of losing diversification," they explain.

Keep in mind, too, that FX markets function well during periods of distress and allow long-short currency managers "to implement their alpha-generating strategies at relatively low cost without major disruptions."

Third, advisors and investors need to keep in mind that they cannot rely on a uniform benchmark for currencies not a uniform currency strategy.

"The distinction of active versus passive is not simple, but investors should nevertheless be able to differentiate between paying for an actual active currency management mandate, or choosing the cheaper alternative of buying securities that track Cyaverage' currency strategies," the Merk team said.

Earlier research has shown that active currency managers can produce consistent alpha, independent of most available strategies, they explain.

"Our simulation, while simplified in its assumptions, indicates that an alpha targeting currency strategy, which exploits the microstructure of the FX market and behavior of dominant market participants, can provide beneficial portfolio diversification while generating excess returns," the authors concluded. "More importantly, globally diverging monetary policy that increasingly drives markets as a whole, does not only substantially impact asset volatility, but simultaneously creates alpha opportunities for the active investor."
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Publication:ThinkAdvisor
Date:Dec 15, 2015
Words:1095
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