7 Reasons Why Currencies Make Sense
12/01/2011 10:00 am EST
To some, the currency markets have a bad reputation, but here are seven reasons why currencies are a viable and profitable asset class that should comprise some portion of every portfolio.
Currencies have been front-page news for the better part of the past year. With all the talk about inflation, interest rates, deficit spending, and national debt, the only thing people understand about currency is that it is the stuff that is in their pocket or bank account.
The US dollar is also the world’s reserve currency, but there has been talk of late about changing that status. But what does that really mean? And should we even care?
Over the past decade, smart traders and investors have been pouring money into the foreign currency market in ever-increasing amounts. They are doing so for a number of reasons.
Let’s take a look and see why having a portion of your trading account money in currencies or foreign exchange makes sense.
Diversity is one of the primary reasons for the growth of this up-and-coming asset class. Astute investors understand the necessity of having assets in many different classes. The currency market is tailor made to fit this need, especially during the times when the stock markets are challenging.
Large institutional investors such as banks, pension funds, trusts, endowments, and family offices have been investing in this asset class for years. As the uncertainty surrounding the US market and economy grows, currencies are the easiest way to globalize and diversify your portfolio.
Little or No Correlation to the Stock Market
Another reason that compels investors to invest in currencies is that they are not correlated to traditional stocks and bonds. Assets are said to be uncorrelated, or non-correlated, when their ability to deliver profits is not dependent on the overall performance of the stock market.
Currency accounts have earned historically high returns over extended periods of time, especially when the stock market has had a rough go of it. For example, in 2008, a year in which the S&P 500 was down 37%, professionally managed currency accounts were able to deliver returns ranging from +13% to +21%.
Since 1980, stocks have had monthly declines of more than 5% 31 times. In 26 of those instances, managed currency accounts have had positive performance for the month.
There have been numerous academic studies conducted over the years which address the proper balance of assets (asset allocation) within an overall portfolio. The key finding is that the introduction of a professionally managed alternative asset class into a portfolio has the two-sided effect of increasing the overall return of the portfolio while also reducing the volatility.
The key is finding the proper balance, which, depending on your risk threshold, lies somewhere between “eat well’ and “sleep well.” The studies also conclude that portfolios with alternative asset classes in them are more tax efficient that those with no alternative asset mix.
Excellent Profit Potential
Investors have typically employed currency trades as a hedge against investments in other international securities. About ten years ago, a few institutional money managers began looking at currencies a bit differently.
They noticed that currency trading strategies gave them the ability to profit in any economic environment. The ability to provide consistent low risk profit streams added an arrow to their quiver.
The world’s most famous currency trade—a bet against the British pound in September of 1992—netted speculator George Soros more than $1 billion in profits.
The Currency Market Itself
Currencies are one of the most flexible investments around. First, the market itself is the largest in the world. More than four trillion dollars is traded each and every day, which is roughly ten times the size of our stock and bond markets combined.
The currency market, according the Financial Times, is the world’s largest, most transparent, and most liquid market in the world.
Currencies trade just like stocks and bonds. There is no official market like the New York Stock Exchange, but the market is an electronic one very similar to Nasdaq.
24 Hour Market
The currency market opens for trading on Sunday at 5pm in New York and trades continuously until the market closes at 5pm Friday evening in New York. The around-the-clock trading gives managers the ability to react quickly to news events and other market-moving events that require action.
Go Long or Go Short
In addition to market size and liquidity, currencies have the potential to be profitable in any type of economic climate. Managers have the ability to go long (buy in anticipation of higher prices) or short (sell in anticipation of declining prices).
This ability to be long or short gives the manager the potential to profit (or lose) in times of: (1) Energy abundance or crisis, (2) Economic strength or weakness, (3) Political stability or upheaval, and (4) Inflationary or deflationary environments.
Managers can trade in one or two currencies or they can spread their portfolio into many currencies at one time. The six largest and most actively traded currencies are the: (1) US dollar, (2) Euro, (3) Japanese yen, (4) British pound, (5) Swiss franc, and (6) the Australian dollar.
Most professional currency managers use trading systems. The average investor flies by the seat of his pants. The trading systems that are used can be either systemic or discretionary. They can also trade in multiple time frames. What this means is that the manager has the flexibility as to both his approach and trade time horizon.
The returns managers achieve can be attributed to factors such as the primary trend, volatility, liquidity, momentum, and arbitrage. It’s interesting to note that the approach used by currency managers tend to be completely different from the tactics used by traditional stock and bond managers.
Trading foreign exchange is an extremely challenging endeavor. The difficulty can be drastically increased when time management is a factor. Toss in some of the emotional ups and downs, and the foreign exchange market can take on a life of its own.
Foreign exchange offers excellent profit potential when it is traded effectively. The question that is most often asked is: “Is this something I can do myself or should I have my account traded by a professional?”
There is no simple answer but sitting down and having a discussion with someone about adding foreign exchange to your portfolio is simple.
Risk: That Pesky Four-Letter Word
My biggest battle, which is one that I have almost daily, is the perception that currencies are “risky.” The folks belittling currencies aren’t my clients or prospective clients. It’s others (like the media or other investment advisors) who either don’t understand what they are talking about or don’t have access to the investment platform itself.
So to those folks I say this: It’s 2011 and the world we live in has evolved. Dinosaurs are extinct for a reason.
Is there risk? Yes, there is. It’s a unique market, and to be successful, you must learn to navigate it with care. Any investment in the hands of an amateur is risky. So is dynamite.
I’ve spent the better part of the last 30 years trading stocks, options, futures, and currencies. I’m pretty good at it. I thrive in the currency market because I have learned and adapted. I have developed, tested, and implemented a comprehensive risk management system. In other words, I have stuff in place that limits my downside risk.
By Robert A. Christy, president and CEO, The Christy Group
Managed currency accounts/funds are offered and sold by memorandum only, which includes additional information of risks, charges, and liquidity. These investments are not suitable for all investors. Please read the memorandum carefully for information relating to fees, expenses and other charges that may reduce returns. These investments can be speculative in nature. You may lose all or substantially all of your investment in certain funds. These investments may employ leverage. An account/fund may acquire positions with a face amount of as much as six to ten times (or more) of its total equity. Leverage magnifies the impact of both profits and losses.
Performance may be volatile.
You will sustain losses if the fund is unable to generate sufficient trading profits and interest income to offset its fees and expenses. In many funds, the units are not liquid. No secondary market exists for the units and you may redeem units only as of month end. Additionally, there may be restrictions on transferring units in the some funds. Early redemption charges may be assessed if you redeem units within a stated period of time.
A lack of liquidity in the markets in which the fund trades could make it impossible for the und to realize profits and limit losses. Certain funds may impose net worth and income requirements before investing in the fund are allowed.
Past performance is no guarantee of future results.