Global Voyage

In the 1990s, when George Soros made headlines–and billions–trading the British pound and Southeast Asia’s currencies, most investment advisors figured his activities were the kind of capitalist warfare practiced by Ghengis Khan in pinstripes, not a low-key, Peter Lynch-style investor. But that’s not really the case. Increasingly, foreign currencies are coming to be regarded as a distinct asset class that can lower risks and add alpha to a portfolio.

This realization is especially relevant given today’s market uncertainty. More than three years of troubled equity performance, coupled with interest rate yields that barely make the switch from cash into bonds worthwhile, have intensified the search for enhanced asset allocation. And “the appeal of foreign exchange exposure,” explains Gary Klopfenstein, president of Chicago-based GK Investment Management, “is that it offers performance that’s uncorrelated with the stock and bond markets, with positive returns possible regardless of which way broad markets are turning.”

With $1.7 billion under management, Klopfenstein backs up his sentiment with solid numbers. His GK Currency Alpha Trading program has generated net annualized returns of 17% since his firm began to focus exclusively on currency trading in 1990. As with many institutional currency programs, getting into the program usually requires an investment of at least $1 million, although advisors may bring in several smaller accounts to reach Klopfenstein’s minimum.

Klopfenstein is hardly alone in consistently realizing gains through foreign exchange exposure. According to International Traders Research, a La Jolla, California-based industry group that tracks the performance of managed futures, funds that focus exclusively on currencies have registered annualized gains of 4.88% from the beginning of 1998 through June of this year. In contrast, the Dow rose 3.27%, the Nasdaq was up 1.81%, and the S&P 500 gained a paltry 0.36% over the same period. Moreover, currency funds have been achieving these returns with less volatility than the broad markets. The group’s monthly standard deviation was 1.63%, versus 5.34% for the Dow, 10.44% for the Nasdaq, and 5.31% for the S&P 500.

“There’s the perception,” explains Jeremy O’Friel, director of Dublin-based Appleton Capital Management, “that investing in foreign exchange is like climbing behind the wheel of a Ferrari. But while some may tear about, it can also be driven at 30 miles per hour.”

The Appeal of Foreign Exchange

Currencies are attractive investments for several basic reasons. Foreign exchange is the largest, most liquid, and most efficiently priced market in the world, trading more than $1.2 trillion every day and never closing. That makes currencies among the most effective ways to diversify a portfolio with performance that’s uncorrelated with traditional investments.

Unlike most other markets where trades are placed to make money, 80% to 90% of all currency investments are made by multinational corporations, central banks, investment managers, and tourist-related businesses simply to hedge their foreign exchange exposure. While specific events such as terrorist acts or SARS can cause temporary sell-offs, currency rates are generally shaped more by capital flows, interest rates, and economic sentiment. “With the bulk of investors not seeking to drive exchange rates in a particular direction,” observes Klopfenstein, “there’s opportunity for the shrewd investor to latch onto these trends.”

Among the most attractive times to invest in foreign currencies is when it appears most risky: when the dollar and U.S. economy appear strong while other places look anemic. However, it is frequently at this time that investors can purchase a large quantity of weaker foreign currencies.

Undervalued currencies often boost exports due to more competitive pricing, helping to revive corporate profitability and demand for domestic securities. At the same time, central banks overseeing weaker currencies will often push up interest rates to increase currency demand and valuation and to counter expanding current account deficits, albeit at the risk of slowing domestic growth. Nevertheless, moving into a currency when interest rates are peaking could lead to bond gains when rates begin to fall.

Foreign exchange trading offers greater flexibility than many traditional investments. While stocks can be shorted, most brokers and investors tend to stick to long positions. Currency traders, on the other hand, can change positions on a dime, being long the euro one moment, then shorting it the next if an opportunity presents itself. Taking a particular position can be done through various “cross-rates.” For instance, if you believe the dollar will rally, you can place bets in favor of the greenback against the euro, pound, and Australian or Canadian dollars.

While it was once difficult for anyone but a professional trader to come by, information on foreign exchange trends and related events is now readily available. Major financial dailies and magazines report regularly on rates and related actions. Many international brokerages and a number of specialty research firms regularly produce foreign exchange reports.

Macroeconomic data–among the most predominant of forces to drive exchange rates–is widely available through the International Monetary Fund (www.imf.org), the Organization for Economic Cooperation & Development (www.oecd.org), and The Economist Intelligence Unit (www.eiu.com), with the latter offering consensus currency forecasts. Other useful currency Web sites include Oanda.com and Forexnews.com, The Financial Times (news.ft.com/markets/currencies), Gaincapital.com, and Fxall.com.

Most currency traders do not try to outguess the market, relying instead on systematic programs that respond exclusively to price trends. However, over the long term, exchange rates are ultimately a reflection of a country’s economic, political, and social conditions and outlook.

For instance, when the euro found itself trading mostly below 90 U.S. cents between August 2000 and August 2001, hindsight was not required to know that it was significantly undervalued. This was especially true when the currency dropped below 85 cents. Indeed, toward the end of 2001, a number of analysts, including Fran??ois-Xavier Chauchat, chief economist at Cr?(C)dit Agricole Indosuez Cheuvreux in Paris, and Joachim Fels, an economist and currency analyst for Morgan Stanley in London, were anticipating the euro rebounding back to parity with the dollar.

Or take the South African rand. It lost more than half its value during the last four months of 2001 for no apparent reason–baffling currency observers, government officials, and economists. However, those who kept sight of the country’s commitment to responsible monetary and fiscal policies, along with its underlying resources and potential wealth, were well rewarded. The currency rebounded to its former strength over the subsequent 18 months.

The most disciplined eastern European currencies, whose countries are poised to join the European Union, may strengthen as they attempt to qualify for their subsequent inclusion in the euro. During the mid-1990s, a host of weak Mediterranean currencies offered a comparable “convergence” play, enabling prescient investors to significantly profit as the Italian lire, Spanish peseta, and Greek drachma strengthened on their way toward euro membership.

The ABCs

For many advisors, currency is rarely a consideration. It surfaces only when purchasing American depositary receipts or foreign securities. And then it tends to be treated as a risk, rather than an opportunity. But an exchange rate actually has dynamics of its own. It reflects international supply and demand for a country’s currency. Key influences include interest and inflation rates, capital flows, balance of trade and current account balances, government balances and debt levels, and economic and political outlook. As a discrete strategy for 5% to 10% of a client’s assets, advisors should consider focusing on quality currencies that appear cheap and then look at global securities as vehicles for playing particular foreign exchange markets.

For example, after its initial surge to $1.18 upon its introduction in 1999, the euro proceeded to decline against the dollar for nearly the next two years. When it closed at 83.9 cents on November 24, 2000, euro-denominated securities had lost 29% of their value due to the effects of currency translation alone.

For the next 15 months, the euro tried several times to rebound, only to find its value tracing back near its historic lows. While that may have appeared discouraging to those who were long the euro, the trading pattern appeared to have been creating a bottom.

After closing on February 27, 2002, at 86.4 cents, the euro proceeded to rally for the next 15 months, surpassing $1.19 by the end of May 2003 and completing a full recovery from where it had started trading nearly three and a half years earlier.

Just as with a stock, waiting for a currency to break out of a downward trajectory and establish an upward trend helps reduce the risk of being on the wrong side of a long bet. Still, traders set quick stop-loss orders to get out when a trend shows signs of breaking down prematurely.

Because the ascent of the euro to $1.19 was remarkably quick and uninterrupted by serious correction, many traders were able to capture a significant portion of the run-up. And advisors who had moved into higher-yielding eurozone government debt did very well, not only through currency appreciation but by declining yields that pushed up bond prices.