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Global Voyage

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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 (, the Organization for Economic Cooperation & Development (, and The Economist Intelligence Unit (, with the latter offering consensus currency forecasts. Other useful currency Web sites include and, The Financial Times (,, and

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.

Another case study is the movement of the Australian dollar. It began its strong recovery in April 2001, after the currency had fallen below 50 U.S. cents and foreign investors had grown nervous about double-digit interest rates and slowing GDP. But where the rest of the developed world had fallen into recession, the Aussie economy continued to expand. The government stuck to responsible fiscal and monetary policies. And the price of many commodities–a key underpinning of the Australian economy–had begun to rebound.

An easy way to have established a long Aussie-dollar position was through some of the country’s largest bank stocks. Throughout the slowdown, they continued to pay dividends of 5% to 7%. Even after they faltered in the aftermath of the Bali terrorist bombing last October, many Australian bank ADRs proceeded to tack on 40% to 50%, aided by a rebounding Aussie dollar, which by early July had broken past 68 U.S. cents, up 36% in little more than two years.

Gaining Currency Exposure

Owning ADRs of HSBC, the London-based global bank, for instance, makes you long sterling. At the same time, the ADR pays an attractive dividend of more than 4% and gives you stock market exposure to boot. However, buying ADRs is only one way to gain foreign exchange exposure.

To avoid equity risk altogether, you could instead buy shorter-term fixed income securities, such as those of AAA-rated governments, multinationals, and “supranationals”–non-governmental organizations promoting economic development that are backed by various central banks and national agencies, such as the World Bank, Asian Development Bank, and the European Investment Bank. Their prices and yields are much more stable and predictable than stocks, and repayment of capital is virtually assured when held to maturity.

General Electric, for instance, often raises capital in various foreign markets to finance ventures and acquisitions, offering currency exposure through a highly rated name. GE Canadian Capital Corp. has an 8.58% coupon that matures in September 2005 offering a 3.55% yield to maturity as of late summer. And the company’s Swiss operation has a 3% bond due at the end of 2004 with a yield to maturity of 0.75%.

For smaller investments, St. Louis-based Everbank World Markets (; 800-926-4922) currently offers certificates of deposits in 13 foreign currencies ranging from the Norwegian krone to the Australian dollar. While yields are less than those being paid in the home markets, the bank does provide efficient exchange rates and trade execution. For example, during the first week of September, South African three-month Treasuries were yielding 10.40%, only 40 basis points more than what an Everbank South African CD was paying.

Accounts can also be set up directly with a number of foreign banks. But the process can be complicated, access is more cumbersome, and investors may be exposed to a host of unexpected fees.

International mutual funds that do not hedge their currency risk are another alternative. For specific rate exposure, look to single-currency exchange traded funds, such as the UK, German, and Australian iShares. While they trade in dollars, their underlying value is directly affected by exchange rates. And since these exchange-traded shares can be shorted, they can also provide long dollar positions.

Among mutual funds investing overseas, Oppenheimer International Bond and American Century International Bond funds both offer diverse currency exposure. But at times their managers may hedge their foreign exchange risk. The funds have low minimum investment requirements, but have higher annual expenses than index equity funds, with front-loaded or deferred loads.

A big step up from individual stocks, funds, or CDs are currency forwards and futures. They are the basic tools of the professional foreign exchange investor, offering margin trades that can generate various degrees of leverage. They are marked to market daily, exposing investors to remarkable upside and unlimited downside liability.

Forwards are customizable contracts traded by banks on behalf of clients. The contracts are typically worth at least $1 million and last from several days to a year and beyond. They enable investors to bet for or against a currency relative to another. Forwards are generally the security of choice for most currency traders, offering greater liquidity and lower costs than futures.

Future contracts are over-the-counter agreements between two currencies that trade on various commodity exchanges in units of $125,000. The Chicago Mercantile Exchange, for example, trades 13 different currencies, involving 30 different cross-rates. A limited number of the most frequently traded pairs involve smaller units of $62,500.

In addition, multinational banks and brokerages, along with foreign exchange specialists, have long offered “currency overlay” services that lock in current exchange rates to secure the foreign exchange costs of future business transactions. Over the past decade, firms such as State Street Global Advisors, Deutsche Asset Management, and JP Morgan Fleming have begun to offer access to programs that invest in currency to “qualified” investors who have a high net worth and annual income.

Many private banking groups also offer comparable programs for wealthy individuals. However, both of these services tend to suffer from a lack of transparency. Reporting is limited, trading strategy is kept under wraps, and there is no independent coverage by tracking groups such as Morningstar.

A way around this shortcoming is to invest through a commodity trading advisor or CTA. A number of CTAs focus exclusively on foreign exchange and have established an impressive record of steady growth with moderate volatility during all kinds of markets.

Several industry clearinghouses track individual program performance, such as International Traders Research (, the Barclay Group (, Lind-Waldock (, and Institutional Advisory Services Group. Two oversight groups, the Commodity Futures Trading Commission ( and the National Futures Association (, help ensure industry integrity and provide investors with extensive information about the ins and outs of commodity trading.

The appeal of CTAs is reflected by their increasing accessibility through major brokerages, including Morgan Stanley, Smith Barney, and Merrill Lynch, which are now marketing currency funds to smaller investors, with minimums as low as $5,000.

Jeremy O’Friel’s Appleton Capital Management 25% Risk Program, for example, has been among the most consistent top-performing currency CTAs over the past five and a half years. From January 1998 through July 2003, the fund has had annualized returns of 11.90% net of expenses, easily outdistancing the major equity indices. And it has done so with a standard deviation that’s comparable to the Dow and S&P 500, and nearly half that of the Nasdaq.

Started in 1995 and now with $110 million under management, this systematically traded program has a minimum investment of $1 million. What makes O’Friel’s fund unusual is that it focuses exclusively on just four currencies: the U.S. dollar, Japanese yen, Canadian dollar, and euro. O’Friel explains that the program limits itself to these currencies because they are liquid, can be forecasted with some accuracy, and are relatively unhampered by political interference.

Like most currency traders, Appleton has been able to make money regardless of the economic cycle or what the broad markets are doing. “Exchange rates are inherently volatile,” explains O’Friel. “But by leveraging bets on established trends and strictly managing risk, traders can be in the money when they are right just 40% of the time.”

Indeed, the inherent appeal of currencies is that they offer continuous opportunities that are largely ignored by the rest of the market. “Exchange rates, even between two industrialized countries with healthy economies,” explains Rudi Weisweiller, author of How the Foreign Exchange Market Works, “can move against each other by 10% or 20% in a year. They can move right back again within a few weeks.” This constant motion is what makes foreign exchange a unique and attractive alternative to traditional investments.

Eric Uhlfelder writes for the Financial Times and The New York Times, and is the author of Investing in the New Europe [Bloomberg, 2001]. He can be reached at [email protected].


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