Investors should keep control of the currency within their portfolio

CURRENCY is the world’s largest asset class by its very nature, as every world market is denominated in currency. Forex is also the world’s largest financial market, with daily currency trading exceeding £1.5 trillion.

Currency shows weak correlation with other asset classes. As an example, if you take the dollar spot price index (USDX) – which compares the dollar against a basket of six other major currencies – and the S&P 500 over the last two decades, they have a Pearson correlation coefficient of 0.38. This means that while there is some correlation, a 0.1 per cent movement in equities listed in the S&P 500 would be accompanied by a 0.38 per cent move in the dollar.

Another useful feature of the currency market is that a worldwide crash, of the type that we saw in 2008 in the equities market, cannot happen in forex. Volatility can go through the roof, but as the value of one currency is expressed in terms of the value of another, they cannot all fall at the same time.

Despite the wide range of advantages offered by currency, a large amount of portfolios have little or no direct currency exposure. There is even debate as to whether currency should be considered as an asset class at all. Naysayers point out that currency in itself does not yield returns. If you buy a basket of currency and leave it to its own devices, you are going to have the same amount of currency in five years time. In traditional asset classes such as stocks and bonds, you can expect a return, as there is capital being used and you benefit from dividends and share price gains. If you want to make returns from currency within your portfolio, you need to take an active role in its management.

In the past, this may have been a challenge for investors as the forex market is a very different beast to the equities market. A degree of leveraging is required to make real returns and currency involves a greater amount of investor sophistication.

However, the rise of currency exchange-traded funds (ETF) has brought an easier way for investors to gain currency exposure within their portfolios.

According to Martin Arnold, senior analyst for ETF Securities, a lot of the asset managers that make use of their currency ETFs are looking to take a direction on deep macro-economic trends driving markets at the moment: “We offer tailored sterling-based ETFs versus other G10 currencies. We also offer emerging market currencies versus established markets, allowing investors to take a position on the renminbi or the rupee and so on”

Alongside currency being held as a standalone asset class, Arnold says that currency exposure through ETFs can be a useful tool for investors seeking to use currencies as an active overlay to stock positions “leveraged products are of use if you are taking an equities position in a foreign currency denominated stock, For example, if you were looking to the US, a three times leveraged sterling-dollar ETF would hedge that trade.”

If they choose not to manage their own currency positions, investors do have the option of buying into currency-hedged funds. According to Jasper Berens, head of the UK intermediary business at JP Morgan Asset Management, “currency risk remains a growing concern for investors. Given this uncertainty, it is right to give investors, who are not prepared to be exposed to both market and currency risk, a choice between share classes to best suit their requirements.” At the launch of a currency-hedged commodity fund, Berens said: “Rather than investing in companies whose primary businesses are related to commodity markets, investors will only be taking commodity risk rather than equity and commodity risk together.”

Whatever your strategy for commodity exposure, what is important is that you must have one. Without it, those gains that you make on a smart US equities move could be wiped out in a second by sterling-dollar movements.