The Case For FX
Owning only one stock in an equity portfolio or only one bond in a fixed income portfolio is not desirable from a diversification perspective.
The same applies to currencies and this is where our dynamic and tightly controlled currency overlay management comes of assistance.
Similarly to other asset classes, separately assessing and managing the Foreign Exchange dimension of a global portfolio enables to mitigate unknown risks (the FX risk factor is present in most portfolios but is often ignored) and to generate additional return.
Foreign Exchange Benefits
1. Modern portfolio theory (MPT) addresses the need to diversify within and across asset classes.
FX markets can be combined with other exposure to generate an uncorrelated additional return.
2. FX markets are deep, liquid, and a cost-effective way to express macro-economic views.
With more than a USD5trn daily turnover, FX markets command the smallest transaction costs of any asset class (less than 1/10th of 1% in most cases). They are also exempt from stamp duties in Switzerland.
3. FX markets are investable around the clock from Sidney to Tokyo, to Zurich to New York, and back to Sidney without interruption every day of the week, from Sunday till Friday. This dimension of continuity offers an additional layer of protection.
4. There is no such thing as “foreign exchange markets being overvalued”.
FX prices (unlike stocks or bonds) are relative not absolute prices. When we buy EURUSD (in the spot, forward, future or options market), we buy EUR and sell USD, meaning we assess EUR in relation to the USD before gaining exposure.
Combining any currency with another to form one “currency pair” opens a wide range of possible combinations to assess the relative merits of one economy and its currency vs. all others.
5. FX volatility is generally smaller than equity volatility most of the time.
6. It is possible to run a currency program with minimal leverage.
7. It is also possible to own Gold or Silver against any major currency by adding a currency overlay to the ownership of the metals.
A USD based investor might prefer XAUEUR to XAUUSD. This can be done by simply adding a short EURUSD position to his/her long XAUUSD exposure.
Foreign Exchange Risks
FX Investing also entails certain risks:
1. A set of FX positions does not guarantee a cash flow such as a coupon or a dividend even if the existence of a yield differential between currencies opens the possibility to earn an incremental carry and implement yield-enhancing strategies.
2. As with all investments and similarly to stocks or high yield bonds, holding foreign currencies may translate into capital losses.