This article appeared in the AIMA Newsletter, April 2002. © Alternative Investment Management
Association (AIMA), 2002. Reproduction of all or part of this article prohibited without the express
written permission of AIMA and the author.
CURRENCIES AS A PERFECT LONG-SHORT ALTERNATIVE INVESTMENT
STRATEGY
By Arun Muralidhar1, FXConcepts
Introduction
An interesting trend in institutional asset management is the increased focus and emphasis on alternative
investment strategies. In recent months, there have been a number of well-attended conferences on this
subject. Even large public funds have indicated an interest in investing billions of dollars in hedge fund
strategies. In large part, this trend can be explained by investors’ desire to find markets other than the U.S.
equity market as a safe guard and diversifier against a market downturn; however, sophisticated investors
have also realised that being pioneers in the asset management area can pay handsome dividends. In this
note we examine the desirable properties of alternative investments and demonstrate that currency
portfolios can be an extremely attractive alternative investment strategy, if not the perfect strategy!
The term “alternative investment strategy” is loosely defined, but one can use the kitchen sink approach to
dub alternative investments as those that go beyond the realm of simple long-only equity and bond
investments. Therefore, investments in real estate, private equity, long-short and short-only strategies,
hedge funds, market neutral strategies2, commodities and, indeed, currencies can be considered as an
alternative to investing directly in international equity and bond markets. These are usually strategies that
are difficult to incorporate into an asset-liability study because investors are constrained from modeling them
either because of lack of transparency, liquidity or difficulty in forecasting future returns. However, in order
for an investment strategy to be effectively absorbed into an overall portfolio strategy on an opportunistic or
tactical basis it should provide a high return and achieve some combination of the following desirable
properties:
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•
•
•
•
•
•
•
Moderate volatility
Low correlation with other investments (especially bonds and equities) and other alternatives
Transparency in the strategy
Consistent application of a successful strategy
Liquidity or ability to withdraw funds at short notice
Ability to engage in the activity in some size
Established track record (to conclude that the returns are from skill and not luck)
Exploitable market inefficiency
Any investor familiar with alternative investments recognises that most of these strategies would fall short
either on liquidity, transparency, ability to engage in the activity in size (e.g., large pension funds often make
investments as small as $10 million in private equity partnerships), or a long track record of consistently
applying a particular strategy. We first describe different aspects of currency strategies that would be of
interest to investors and use these features to demonstrate the optimality of currencies as an alternative
investment strategy.
The author is a Managing Director at FX Concepts, Inc.. He was previously a member of the World Bank’s Investment
Management Committee and Head of Investment Research. He was also a Managing Director at JP Morgan Flemings Asset
Management and served as Head of Currency Research. Thanks to Landis Zimmerman, Narv Narvekar and Dale Kunkel for
planting the seeds for this note.
2 A caveat here is that there are many strategies under the market-neutral umbrella depending on what aspect of the market the
strategy is neutral to.
1
This article appeared in the AIMA Newsletter, April 2002. © Alternative Investment Management
Association (AIMA), 2002. Reproduction of all or part of this article prohibited without the express
written permission of AIMA and the author.
Currency strategies
Currencies can be considered an alternative investment strategy because holding currencies passively is
not likely to yield a long-term return. Hence, it is rare to find an institutional investor make a strategic
allocation to a currency portfolio in their asset benchmark. However, active currency management is
predicated on the inefficiencies in currency markets, which allow currency managers to make profits from
currency moves. A common occurrence in currency markets is that the forward exchange rate is often a
poor predictor of the future spot exchange rate.3 Currency managers adopt fundamental and technical
indicators to determine relative currency valuations and trends and these strategies have proven to be
profitable over the last decade.4 These are fairly simple strategies. They are not a black box approach to
currency management and are likely to be successful in the future.5
Currencies are unique - every currency trade is effectively a long-short trade (i.e., a long USD/Yen position
in the 3-month forward market is effectively borrowing 3-month money in Yen to invest in 3-month USD
deposits) and, as a consequence, is a self-financing trade.6 Therefore, currency alpha is “transportable” and
can be added to any underlying investment strategy - equities, bonds or cash. Currency alpha can be
captured in portfolios through two modalities – currency overlay strategies applied to global investments and
absolute return strategies are applied over a LIBOR benchmark. The underlying philosophy of these two
strategies is identical; namely, to add alpha over a given benchmark. However, the overlay strategy targets
an alpha of 1.5%-2%, whereas the absolute return strategies can use some leverage and target alphas in
the 15-20% range.
The case for currencies as an alternative investment strategy
Probably the most compelling case for including currency alpha in an overall portfolio strategy as an overlay
strategy is that these strategies have generated consistent alpha7. It is interesting to note that one can be
80-90% confident this alpha has been generated with skill.8 Even though currency mandates have been in
place for just over 10 years, one is able to find a high degree of skill even in mandates that have been in
place for as few as 4-5 years
The more interesting research with respect to currencies is that currency alphas appear to be uncorrelated
with basic investments in bond and equity markets.9 In addition, and more important to the alternative asset
investor, is the fact that these strategies lack correlation with the standard alternative strategies. This is
demonstrated in Table 1. Strategy 1 is a currency strategy that focuses only on developed market
currencies, whereas Strategy 2 includes emerging market currencies. This is very important because it
would seem to suggest that these alphas are being exploited from market inefficiencies that no other basic
investment strategy or alternative investment strategy can capture. The only strategy with a reasonable
correlation is the macro hedge fund wherein currency strategies are embedded. Therefore, investors will
benefit from incorporating such a product, as it is risk reducing at the overall portfolio level. In reviewing the
correlations of the currency programs with other asset classes and alternative strategies (Table 1), an
equally compelling case can be made for including aggressive currency products in overall portfolios as they
See Baz et al (1999).
See Strange (1993), Levich and Thomas (1993), Baz et al (1999), and Muralidhar and Tsumagari (1999).
5 See Muralidhar (1999b).
6 At maturity, the forward contract is either in-the-money and the investor receives cash from the counterparty or out-of-the-money
and the investor must post cash to the counterparty. However, no cash is required at the initiation of fairly priced forward contracts.
7 See Strange (1998).
8 See Muralidhar (1999a).
9 See Baz et al (1999) and Muralidhar (1999b).
3
4
This article appeared in the AIMA Newsletter, April 2002. © Alternative Investment Management
Association (AIMA), 2002. Reproduction of all or part of this article prohibited without the express
written permission of AIMA and the author.
are for alternative asset portfolios. Therefore, including such a product in an overall portfolio strategy
effectively raises the efficient frontier of available investment opportunities.
Finally, the additional reason to adopt a moderate or aggressive currency alpha strategy in an investment
portfolio is the fact that the currency market is one of the largest and most liquid markets in the world with
approximately US$1 trillion being transacted daily. Therefore, investors are not constrained in the size of
their investments and, most important, can liquidate the strategy almost instantaneously without having
significant market impact. This cannot be said of many other alternative investment strategies!
Conclusions
As investors extend the scope of investment strategies considered under the alternative investment
umbrella, they are constrained by the lack of transparency, liquidity, and volume/size of these strategies. In
addition, a number of these strategies depend on the abilities of certain individuals rather than a formal
application of an investment process. Research and experience in currency markets has shown that by
applying a consistent, formal, transparent, investment process to investor portfolios, that investors can
capture moderate to aggressive alphas in currency markets. These currency returns have the unique
characteristic that the high returns are coupled with moderate volatility, and, most important, a lack of
correlation with other basic investment strategies. This lack of correlation is an important ingredient in
reducing the overall risk required to achieve a target portfolio return. Further, the currency market is rife
with inefficiencies and it is fairly easy to tell within a short time frame whether currency managers are lucky
or skillful. All these desirable properties make currencies a unique and extremely valuable, if not the ideal,
alternative investment strategy.
This article appeared in the AIMA Newsletter, April 2002. © Alternative Investment Management
Association (AIMA), 2002. Reproduction of all or part of this article prohibited without the express
written permission of AIMA and the author.
Table 1 – Correlation of currency strategies with various strategies
(January 1995- August 2001)
Strategy 1
Strategy 2
Long/Short Equity
0.09
0.17
Event Driven
0.09
0.24
Global Macro
0.23
0.33
Fixed Income Arbitrage
-0.29
-0.05
Emerging Markets
0.06
0.34
Equity Market Neutral
0.27
0.18
Convertible Arbitrage
-0.17
-0.01
Managed Futures
0.39
0.27
S&P 500
0.17
0.18
EAFE
0.13
0.16
World Government Bond Index
0.15
0.18
Source: TASS, Datastream, Bloomberg, FX Concepts, Inc.
REFERENCES
Baz, J., F. Breedon, V. Naik and J. Peress (1999). Optimal Currency Portfolios: Trading on the Forward
Bias. Lehman Brothers Analytical Research Series, October 1999.
Levich, R., and L. Thomas (1993). The Merits of Active Currency Management: Evidence from International
Bond Portfolios. Financial Analysts Journal 49, No. 5, September/October 1993.
Muralidhar, A. (1999a). Currency Overlay Performance: Luck or Skill? Investments and Pensions – Europe,
September 1999.
This article appeared in the AIMA Newsletter, April 2002. © Alternative Investment Management
Association (AIMA), 2002. Reproduction of all or part of this article prohibited without the express
written permission of AIMA and the author.
Muralidhar, A. (1999b). Enhancing Performance through Currencies in a Risk-Controlled Way. Global
Pensions, forthcoming January 2000.
Muralidhar, A. and M. Tsumagari (1999). A Matter of Style. Futures and OTC World, Issue 336, April 1999.
Strange, B. (1998). Currency Overlay Managers Show Consistency. Pensions and Investments, June 15,
1988.