Movies, Indian Food and Foreign Exchange

`Movies are a fad. Audiences really want to see live actors on a stage,' Charlie Chaplin once said. Bearing in mind Chaplin was a huge screen star at the time of the statement we can see how hard it is to judge which fads are destined to be just that, and which are likely to stick and become mainstream.

The age old debate rumbles on in the world of finance as to how many asset classes there are (the divide often occurring between academics and practitioners). My first economics teacher thought that the only real asset classes were cash, bonds, equities and commodities. I can't be entirely clear on his position on this point, or many others for that matter, as most of my attention in those economic lessons was dedicated to the lovely German girl sitting next to me who in her list of accomplishments can claim to have subsequently achieved an A at economics A-level whilst residing myself to a B merely through her very attendance in class.

The picture today is not so clear. We have to consider commercial property, hedge funds and the topic of today foreign exchange (FX) as potential separate investment asset classes. The jury is not yet out for many in the 'hedge fund - separate asset class?' debate. But for me it is. Recent surveys have shown that most investment professionals (practitioners) are treating them as a separate asset class (45% against 12% integrating them in traditional asset classes) and these are the people that matter.

So after all the talk, institutional announcements, press articles and general debate can we see FX as a separate asset class or merely a passing fad or the flavour of the month?

It is clearly growing in popularity but the question is whether that popularity grows to sufficient levels and sustains itself.
It then occurred to me that the term 'fad' or 'flavour of the month' need not be mutually exclusive when mentioned in connection with a new product, fund, or investment class. Why should something that is flavour of the month in November 2006 not still be going strong in January 2020? Surely something that starts out as a `fad' can turn into something with longevity. All that is needed is time and hindsight. `Fads' and 'flavours of the month' are merely short term perspectives.

When the first Indian and Chinese restaurants opened up in London in the early 70s few would have predicted that 30 years later Indian food would turn into the favoured cuisine of the English and that none other than chicken tikka masala become the national dish. Like Indian food, FX is not a new thing it has been around for a long time. But only recently has it come so far to the forefront as to become a major discussion point. The question remains whether it can maintain popularity and sustain performance for long enough to secure itself as a separate investment asset class.

Consider for a moment the good old hedge fund industry. And that is just what it is, old. When, back in 1949, Alfred Winslow Jones went about his investment strategy of taking short positions in his equity market share dealing he could not have envisaged the multi-billion dollar industry of today. It has only been recently that the industry has really taken off. As recently as the early 90s the hedge fund industry was not at the forefront of the financial market's psyche. It wasn't until the late 90s that, as the markets began to struggle and traditional investment strategies started to lose money, attention shifted to hedge funds. They were miraculously still making money. It was at this point that their incredible growth began.

It is somewhat tricky to map their rise in popularity as they are not obliged to report their figures. However, going on guestimates by JP Morgan Chase, they show an increase from $38bn in assets in 1990 to a post-lift off figure of $817bn in 2003. In the last 3 years it is also predicted that this figure has risen to around $1.2 trillion. So although hedge funds have been around for a long time and the underlying essence of them is still the same, they could only really claim to be a separate asset class once they started receiving the volumes of allocation and were treated accordingly by investment professionals.

Can the FX market be viewed in the same way?

To really get to the bottom of this, one needs to look at the hard facts behind the FX story. One of the problems about the FX story is that so few investors know much about it or have consciously had exposure to it. Unfortunately due to the nature of FX it has been hard for the people to gain an impression of the returns connected to it due to the lack of an established index or benchmark. With other asset classes it is somewhat easier as there are indexes one can look at to gain this fundamental knowledge about the market. Unfortunately for FX there is not an established index or benchmark. Some might argue it is no surprise FX is not an established separate asset class if it doesn't even have an index or benchmark.

The reason behind this is simple. You can't look at currencies as the underlying factor of a currency index in the same way you can look at share prices as the underlying factor of an equity or bond index. This is because FX's very existence is based on the fact that for one currency to get stronger it requires another currency to weaken against it, therefore currencies are always inter-connected. Take USD/GBP for example. By taking a single position with this pair by definition you are going long in one currency whilst going short in the other. Calculating market capitalisation for two currencies also becomes somewhat tricky. Should it be done on all open positions for USD/GBP or on the net position of the USD/GBP? For these reasons it is somewhat understandable that FX has not had an index for so long. But change is around the corner. In recent months Deutsche Bank has committed resources to putting together an unbiased and meaningful benchmark for FX. The chances are that others will follow.

I can't go into detail about how the index is compiled, that would take the better part of the rest of this magazine. But in brief, it takes the top ten developed world currencies (USD, GBP, Euro, Yen, etc) and then looks to take positions in the top three of those currencies for the three widely accepted FX investment styles, carry, momentum and valuation. The benchmark is then an average of these three investment styles.
What has the Deutsche Bank benchmark shown us? It has dispelled the traditional myths about the returns and volatility of FX. Long term returns have been comparable to those associated with equities and bonds, if not slightly better, and risk-adjusted returns have been equally as good. When looking at FX over the last 25 years, a period where most currencies have been fairly flexible and free floating, post 'gold standards' and 'bretton woods systems' etc, we can see that sustained solid performance has been achieved. Over the 25 year period up to 2005 FX returns were 12% compared to that of equities (11%) and bonds (10%). Over the shorter investment period of the last 15 years FX has been able to provide an 8% return compared to 7% for both bonds and equities. It is important for an asset class to perform strongly in its own right but is also important to perform independently of other asset classes. The benchmark has shown us that FX has very little correlation with bonds and equities, 12% and 2% respectively, compare that to a correlation of 19% between bonds and equities.

Other recent news seems to be suggesting a change in perception of FX by many fund managers and pension funds. Tower Group, a financial services research consultancy, recently reported that FX volumes have and will continue to increase dramatically so that by the end of 2007 we are likely to see somewhere in the region of $3,600bn in average daily trading volumes, up from the $1,700bn average daily trading volumes in 2005. Surely increases in figures like these can only be explained by large numbers of investment professionals, fund and pension managers treating FX as an asset class in its own right? 2007 promises to see a lot more structured retail FX products entering into the market and this is likely to be instrumental in driving volume growth further.
It seems time and hindsight will answer whether FX will become a separate investment asset class in its own right. Still, the evidence at the moment suggests FX is set to go the way of Indian food and movies. We'll just have to wait and see.