The last 18 months have brought enormous growth in the number of UK pension funds adopting currency management. The reasons for this include an increasing awareness of the return opportunity in currency; the growth of international investment by UK funds, and the associated increase in the contribution of currency to asset returns; the fall in value of many foreign currencies – and the dollar in particular – having highlighted this increase with its negative impact on international asset returns; and the fact that a growing number of currency managers now have independently verified track records. The growth has not been confined to the UK – many investors all around the world are also looking at and/or implementing currency management through either pooled fund investments or segregated currency overlay. Figure one highlights this growth.
Is all this interest in currency a fad, or is there some substance behind it? Analysts suggest that the currency market is fundamentally different from other investment markets in several ways. You could even say that the currency market is not an investment market at all, but a clearing house for all cross-border cash flows. Those cash flows arise from all sorts of activity: trade, mergers and acquisitions, tourism, business travel, central bank reserve maintenance and management, and, of course, portfolio investment. None of these participants, who make up as much as 95 per cent of the turnover of the market, has making profit from currency trading as one of their targets. Those involved in trade or mergers and acquisitions aim to make profits from their other business activities, but for them currency is a nuisance, not a source of profit – tourists and business travellers clearly do not trade currency for profit, central banks have macro-economic and/or politically inspired aims and even portfolio investors make decisions on the basis of factors that may include, but are rarely driven by, currency.
Not only is the currency market dominated by participants who are not in it for the profits it can generate: it is also the most heavily traded – i.e. liquid – market in the world.
Daily turnover is $1900bn per day according to the most recent of the triennial Bank for International Settlements surveys – some 30 times the daily turnover on the New York Stock Exchange, or 240 times the turnover on the London Stock Exchange.
The diverse and non-profit-centred motivations of the people active in the currency market, and the high liquidity of the market, are unique characteristics. They lead to what economists think of as an ‘inefficient’ market, meaning that prices behave in predictable patterns (for example, the tendency of currency prices to move in trends).
In a happy twist, while the currency market is ‘inefficient’ in these technical/economic terms, its liquidity makes it exceptionally efficient in terms of the cost of trading: a typical transaction might cost 0.02 per cent of the amount traded in transaction costs, with no commissions or taxes at all, compared with many times that for a typical equity or fixed income trade, with commissions and, in some countries, taxes payable as well.
The combined low economic efficiency and high pricing efficiency in the currency market make it an ideal market for active management to flourish. This is because the non-profit-focused participants in the market create opportunities for currency managers (who are profit-focused) to benefit at their expense.
Many of the non-profit-centred participants have no choice in their trading in currency; and many do not measure their currency profits or losses in the same way as currency managers, or even at all. Not only does the structure of the market open up opportunities for currency managers in this way, but the high pricing efficiency of the market makes trading extremely cheap and highly secure; uniquely the risk of being caught in a liquidity crunch is exceptionally low.
Various analyses of currency manager performance supports the case that currency offers significant opportunities. The longest-running of these surveys is published by Russell Mellon, and this now has a 10-year history. Figure two presents the results of their monitoring of both currency managers’ and other asset managers’ value-added generation. While the number of currency managers participating in this analysis is dwarfed by the number of equity and bond managers included, the picture it paints nevertheless speaks for itself.
