3 ‘Compelling’ Reasons to Add Currencies to Portfolios: Merk

As for reducing annualized volatility, the only alternative asset class allocations that did so were currencies (both active and passive), hedge funds and managed futures. But again, only active currency and managed futures "lead to a meaningful increase in the risk-adjusted return of the portfolio," the authors stated.

Passive currency allocation results in a reduction of the portfolio standard deviation, but at the expense of a reduced return, the report adds. "This makes the obvious case for active versus passive currency management in multi-asset allocations, i.e. the ability to provide an uncorrelated return stream to the portfolio that harvests alpha in the long run," wrote Merk and Lucas.

Furthermore, the research demonstrates that currencies "have attractive characteristics in the portfolio-design context, and that there is potential value, both conceptually and empirically, in considering actively managed currencies as opposed to prevalent market indices," they state.

Conclusions

The foreign-exchange market's large size and low trading costs mean advisors and investors have room to employ "highly scalable strategies," according the Merk report. "This is particularly relevant during periods of extreme market conditions, when execution generally becomes less efficient … and execution risk in the FX market remains relatively low … particularly for G10 currency forward transactions."

During these periods, correlations generally moving closer across asset classes, but currencies tend to remain relatively uncorrelated, they add.

Merk and Lucas offer three influential reasons to act on their research.

First, they argue, managed currencies should be considered an asset class "for the same reason that other popular alternative assets are.

In addition, since correlations of currencies with traditional investments are more favorable, showing lower and more stable correlations with equities, their research "suggests, partial allocation to managed currencies in multi-asset portfolios is especially effective in mitigating downside volatility and maximum drawdown."

In other words, advisors and investors who want to protect portfolio need to "broaden their horizon and be mindful of the powerful diversifying effect that currencies can have," according to the Merk researchers.

Second, it's worth looking at the benefits of participating in an inefficient market in which the majority of investors (MNCs, for instance) do not expect to maximize their returns.

Such inefficiencies give active market participants the chance to generate excess returns "by providing liquidity, oftentimes more pronounced during turbulent markets, when multi-asset portfolios are especially at risk of losing diversification," they explain.

Keep in mind, too, that FX markets function well during periods of distress and allow long-short currency managers "to implement their alpha-generating strategies at relatively low cost without major disruptions."

Third, advisors and investors need to keep in mind that they cannot rely on a uniform benchmark for currencies not a uniform currency strategy.

"The distinction of active versus passive is not simple, but investors should nevertheless be able to differentiate between paying for an actual active currency management mandate, or choosing the cheaper alternative of buying securities that track 'average' currency strategies," the Merk team said.

Earlier research has shown that active currency managers can produce consistent alpha, independent of most available strategies, they explain.

"Our simulation, while simplified in its assumptions, indicates that an alpha targeting currency strategy, which exploits the microstructure of the FX market and behavior of dominant market participants, can provide beneficial portfolio diversification while generating excess returns," the authors concluded. "More importantly, globally diverging monetary policy that increasingly drives markets as a whole, does not only substantially impact asset volatility, but simultaneously creates alpha opportunities for the active investor."