With my recent relocation to Japan, I have been contemplating the challenges, risks, idiosyncrasies and opportunities of that greatest of financial games: ‘global asset allocation’.
From the gleaming towers of Tokyo to the ‘square mile’ of London and the skyscrapers of Wall Street, one thing seems clear: after a decade of hearing “currency evangelists” preaching the merits of currency as an asset class, I think that their time may finally have arrived. With the continued dramatic expansion in both the volume and variety of cross-border investment, the management of currency risk – and the use of currencies as a source of investment alpha – will play an increasingly important role.
Currencies have never quite been given their due in the world of asset allocation. While currency considerations have always been central to fixed-income strategies, and while we have recently seen the return of macro hedge funds and currency arbitrageurs, for most investors, currencies have been seen as a mere by-product of an underlying securities transaction. But with reduced expectations for equity market performance and the return of currency volatility, plan sponsors and multi-asset class portfolio managers have become increasingly interested in currencies as an asset class that can both reduce total portfolio risk and add alpha.
Remember the dramatic decline of the euro from its inception at 1.1697 in January 2000 to a low point of 0.8225 in June 2001? European holders of US dollars would have experienced a 29% appreciation in the value of their holdings without even turning on their Bloombergs. And those prescient portfolio managers that acquired euros at those bargain-basement valuations saw them rise to over $1.29 by February 2004 – a dollar-denominated return of over 55%. Similar returns would have been enjoyed by Japanese investors in Australia, as the value of the Ozzie dollar soared from 55.23 yen to 85.48 yen over the same period. This kind of volatility creates extraordinary risk and opportunity.
Notwithstanding currency as an asset class in its own right, consider how currency volatility is complicating life for investors in cross-border equities. For example, domestic US equity investors have enjoyed a stellar year, with the MSCI USA showing a US Dollar return of 26.8%. But over the same period, the dollar depreciated 19.5% against the euro. Which means that Europeans investing un-hedged in the US saw a currency-adjusted return of only 5.5%. An opportunity cost that many chronically under-funded pension plans can ill afford.
Nothing is permanent in global markets except relentless change and the future remains bright for those wishing to benefit from the volatility of currencies. Will the founding European member states get their fiscal houses in order? What will be the impact on euro valuations when 10 new EU member states join the single currency?
In Asia, there is a growing belief that the People’s Bank of China will soon sanction a revaluation of the renminbi. Will the Bank of Japan be able to prevent the appreciation of the yen in light of such realignment?
Obviously, currency volatility isn’t going to disappear anytime soon and sophisticated investors will have to deal with it – either as passive managers of currency risk or as active currency managers seeking to generate alpha for their portfolios. A comprehensive strategy of currency overlay for risk management and return enhancement would seem perfectly suited to this environment of continued volatility.
But the practice is a devilishly complex, labour-intensive combination of science and art – including as it does decisions about what volumes of which currencies are to be hedged, in which combinations, taking into account correlations between currencies and between currencies and equities. And as currency positions are never static, currency overlay must be dynamic and constantly evolving in accordance with the economic and financial fluctuations that buffet world markets.
Clearly, portfolios are in need of protection and enhancement. To achieve these goals investors will have to increasingly rely on specialist currency managers who understand operational risk management, trade execution systems and sophisticated computer models that include such variables as fiscal and financial market events, measures of investor behaviour and sentiment as well as currency performance. The real-time, three-dimensional shifting of the world’s currencies is indeed complex – but global portfolio managers and plan sponsors have no choice but to step up to the challenge of managing currency fluctuations that can measurably enhance or diminish the performance of even the most thoughtfully constructed investment portfolios.
Stephen Smith is managing director and general manager State Street Bank, Tokyo branch

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