Active currency's risk management merits in moments of crisis
“Is the U.S. stock market bound to hit the skids?”¹ No one knows for sure. However, the S&P 500 Index's trailing price-to-earnings ratio has climbed to 22, leaving some equity investors concerned about the prospects of a big move down.²
Yield-starved bondholders could be vulnerable to capital losses, too, if credit conditions deteriorate or interest rates rise. In an environment “where valuations for most asset classes are stretched, and where the probability of a global recession in the next two to three years is relatively high,” the time seems ripe for alternative investments oriented toward risk management.3
Macro currency strategies strive for diversification when it's needed most
Financial assets often react in lockstep to negative news, and when an external shock sours investor sentiment, high correlations among a portfolio's conventional holdings can undermine traditional diversification techniques and make losses more pronounced. Allocating to investments that behave differently than stocks and bonds can help mute the effects of extreme price declines in mainstream markets. Macro currency strategies, in particular, have the potential to rise even when equity and credit markets fall.
An absolute return focus lends itself to heightened macro risks
Macro risks have been growing increasingly relevant as central bank policies diverge, political uncertainty rises, and economic transformation accelerates across the globe. An absolute return-oriented currency investment provides a potential source of return that's not correlated with traditional asset classes, thereby offering the possibility to counterbalance portfolio vulnerabilities, especially in difficult phases of a market cycle. Unlike less liquid alternatives with high transaction costs, the massive, continuous foreign exchange trading volume makes the market for currency among the most liquid and cost-effective in the world.
How did currency strategies fare during some of the darkest hours in recent memory, including those in 2008? The category outperformed global equities by 10%, on average, during each of the MSCI World Index's 10 worst calendar months since before the global financial crisis.4
While we believe there's a strong risk management argument for maintaining a dedicated foreign exchange strategy within an investment portfolio during all market environments, the case for an active currency program becomes that much stronger when stocks and bonds trade at expensive valuations. Rather than relying on a generally rising market, currency managers can seek returns by trying to identify relative value discrepancies. Buying (going long) one currency requires selling (going short) another currency. As a result, macro currency strategies offer investors the potential for positive performance precisely when the opportunities elsewhere are scarce.
1 “Global Markets Update,” Capital Economics, 6/16/17. 2 FactSet, 6/22/17. 3 "Hedge Funds: Still Worth Investing In?" BCA Research, 6/16/17. 4 First Quadrant, 2017.
The S&P 500 Index tracks the performance of 500 of the largest publicly traded companies in the United States. The MSCI World Index tracks the performance of publicly traded large- and mid-cap stocks of developed-market companies. The Barclay Currency Traders Index tracks an equal-weighted composite of managed programs that trade currency futures or cash forwards in the interbank market. It is not possible to invest directly in an index. Past performance does not guarantee future results.
Diversification does not guarantee a profit or eliminate the risk of a loss.
Trailing price-to-earnings (P/E) ratios measure a company's current stock price as a multiple of its trailing 12-month earnings.
Correlation is a statistical measure that describes how investments move in relation to each other, which ranges from –1.0 to 1.0. The closer the number is to 1.0 or –1.0, the more closely the two investments are related.