Some firms go as far as to suggest that investors put a considerable percentage of assets into currency-based strategies. Bilal Hafeez, the global head of foreign exchange strategy at Deutsche Bank, published an influential paper, Currencies: Pensions’ Savior?, last August in which he recommended a 20 to 30 percent allocation.

Since 1980, forex has exhibited long-term systematic returns that are comparable, if not better, than both bonds and equities.

Though Hafeez’s research was tailored to the needs of institutional investors, his conclusions, if valid, would also apply to private investors. "[Foreign exchange] has exhibited long-term systematic returns, or beta, that are comparable, if not better, than both bonds and equities since 1980," he says. "It also has greater liquidity than both." Foreign exchange returns also exhibit very low correlation with returns in the equity and bond markets.

By long-term systematic returns—beta—Hafeez is referring to the return attributed to market performance in general, rather than manager trading or selection skill. Beta is often measured by a benchmark index for a given market—the risk and return produced by the S&P 500, for example, reflects the beta of large-cap U.S. equities. Investors who want to earn the market’s beta return can therefore put their assets into products linked to the S&P 500.

However, it is far more complicated to capture the beta of currencies. While it is easy to create a benchmark for broad-market returns in equities—simply aggregate the performance of a given number of stocks, weighting them by some criteria, typically market capitalization—creating a benchmark of currency returns is another matter. Securities have an intrinsic value. But the concept of value in foreign exchange is determined by how one currency moves in relation to another. Investors can have long positions in equity or bond markets, but in forex markets, to be long in one currency means, by definition, to be short another. "If you have currency and you just sit on it, then you just have risk in your portfolio," says Pierre Lequeux, head of currency management at ABN Amro Asset Management in London. "You need to have an investment process attached to currency in order to release the value of foreign exchange." There is therefore no natural or easy way to create a beta benchmark for currency returns.

One work-around is to aggregate the performance of foreign exchange-only fund managers. However, as with the hedge fund indices that adopt a similar approach, this is fraught with a number of well-known problems, such as the selection bias of managers, a lack of representation and survivorship bias—the tendency for funds that have gone out of business to fall out of the index, leaving only the strongest players and skewing the index unrealistically upward.

As an alternative, Hafeez suggests building an index using a number of replicable rules. He would allow a currency strategy into this benchmark if it meets several criteria. First, it must involve one of the world’s top 10 currencies, in order to have a high degree of liquidity. It must also fall into one of three of the most widely used forex investment styles: (1) It must have a positive yield, also known as "carry"; (2) it must have positive momentum; and (3) it must be undervalued. The specifics of how each individual trade is put in place are complex, but these three strategies are the main ways foreign exchange managers get value out of the market.

When back-tested to 1980, these combined investment styles deliver annualized returns of 12 percent, with a Sharpe ratio (a measure of risk-adjusted return; the higher the ratio, the better the historical risk-adjusted performance) of 0.92. The equivalent for equities is 11 percent annual return and a Sharpe ratio of 0.27, and for bonds an average annual return of 9 percent with a Sharpe ratio of 0.38. Meanwhile, equities and bonds have had a 20 percent correlation in monthly returns since 1980, but the combined forex strategies correlated just 2 percent with equities and -12 percent with bonds. On paper, at least, this means foreign exchange is a good diversifier of portfolio risk. The results led Hafeez to conclude that investors may be missing opportunities to improve their portfolio performance by not having pure forex exposure.

Sobering Realities
This all sounds good in theory, but some observers question the wisdom of allocating so much capital to foreign exchange strategies. "I agree with the general principal put forward in terms of the general diversification of the product, but I think the issue of 20 to 30 percent participation in the portfolio is probably more of a mathematical result than a rational result," Lequeux says.

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