TOP VIEW Investors have long viewed currency trading as a niche investment rather than a distinct asset class. However, some now suggest that because risk-adjusted foreign exchange returns have outperformed other asset classes, currency trading should take a larger role in investors’ portfolios. Theoretically, this seems promising, although executing such a strategy is not as straightforward as it sounds. Many remain wary, arguing that the existing currency exposure that arises naturally from having an internationally diversified portfolio is enough forex risk for most investors.

Thomas Melcher, a Philadelphia-based chief investment officer with Hawthorn, a division of the PNC financial services group that advises clients with more than $20 million in assets, has other concerns. "Much like the research on hedge funds, I think there is clearly merit in the discussion of foreign exchange as an asset class. But the questions are, what does it look like for an investor after tax, after transaction costs, and how do you implement and execute it?" he says. Even an ultrahigh-net-worth individual would struggle to replicate Deutsche Bank’s index returns, and Melcher says he has never heard of asset managers who run money along these lines. "But let’s say you find that manager. That manager is still going to have to charge a fee. And primarily, when you’re dealing in the currency markets, it’s often through futures, and so the composition of those returns is likely to be much more heavily weighted toward short-term capital gains [which have a tax disadvantage] than long-term capital gains. So for the U.S.-based investor, management costs, transaction costs and tax costs can eat away a significant amount of any return that’s out there," he says.

The approach raises some broader questions, Melcher notes. To evaluate foreign exchange risk and return in the context of a diversified portfolio, Deutsche Bank used a Markowitz model, which takes figures for expected risk, return and correlation on different assets and calculates optimized portfolio weightings. The model produces an efficient frontier that represents the best combination of asset weights. Using the analysis by Hafeez, adding foreign exchange to a core portfolio of bonds, equities and cash improves the returns for any given level of volatility.

The problem here, Melcher says, is that the model does not take into account the secondary currency exposure that the rest of the portfolio already has from investing in international markets. "The real question is, if you implemented this strategy and put 25 percent exposure into foreign exchange, would you really have 25 percent currency exposure, or would you have 50 percent currency exposure because of all the other things going on in the background? That’s a tricky question for me," he says. "There is a gap between what things look like in an academic setting and how they translate to the real world." (Click image to enlarge)

Melcher therefore recommends a cautious approach to treating foreign exchange as an asset class. For investors who wish to place a portion of their portfolio with currency-only managers, he recommends allocating no more than the amount exposed to alternative asset classes. On the other hand, those who wish to extract value from the currency exposure that their international portfolio already endures could adopt a currency overlay strategy, which involves outsourcing the management of currency exposures resulting from regular investments in global markets to a specialist, who attempts to tactically manage that risk and improve overall portfolio returns (see "World Beaters" ).

Until evidence emerges that the theoretical benefits of adopting foreign exchange as a distinct asset class can be obtained successfully in the real world, or until financial wizards turn hypothetical indices such as Deutsche Bank’s into actual, investable products whose performance can be analyzed over time, prudent investors may continue to view foreign exchange as an alternative, rather than a primary, part of their portfolio.

John Ferry is an Edinburgh, UK-based financial journalist and a senior correspondent for Worth.

Additional Information
 The Key to Currencies: Class Conscious