The Case for Fundamental Currency Management
Consensus wisdom holds that fundamental value is a less reliable concept for currencies than for markets. But our research shows that exchange rates tend to revert to their fundamental value over shorter time horizons than market prices. We believe they are also likely – with high statistical confidence – to return.
This argues for a greater reliance on the use of value/price investment signals in dynamic currency management than in asset class management, which is likely contrary to what may be deemed appropriate. by the consensus wisdom of global investors.
Asset in global currencies
We expect currency to be a significant contributor to the risk taken – and likely to generate a commensurate return – in our long-term multi-asset portfolios. That is, the active risk budget allocated to currency exposures often approximates, and in some cases exceeds, the active risk budget allocated to equity and bond market exposures over time.
One of the reasons for this large allocation of the risk budget to currencies is the diversification benefit that a dynamically managed currency strategy is meant to provide within a larger global multi-asset portfolio. Over the long term, currencies have no correlation with traditional assets and markets and therefore should be expected to deliver performance that is generally uncorrelated with market-based exposures.
We believe this relationship between currencies and markets is embodied in our team’s long-term, forward-looking Equilibrium risk model. Over shorter time horizons, and incorporated into the team’s short-term, forward-looking Outlook risk model, correlations between currencies and markets can be non-zero, but they tend to still be low relative to, for example , the correlation of one stock market to another, or from one bond market to another.
This means that even if active currency risk is significant in isolation, its contribution to total portfolio risk should generally be small due to diversification effects. This is the experience of our team for more than two decades.
The inclusion of currency therefore has the potential to “overweight” the return contributions and risk contributions of a dynamically managed multi-asset portfolio, and this argues that a active currency is used significantly over time, even if there are fewer currencies in the investment universe than there are markets (there are more than 30 currencies in the our team’s investment, against more than 75 different “buckets” of equities and fixed income securities that represent countries, sectors and credit categories).
Another reason for the generous use of the FX strategy in our team’s portfolios is the effectiveness of returning the exchange rate to fundamental value. The foundation of our team’s investment process is the determination of the fundamental values of asset classes, markets, sectors and currencies, and the identification of investment opportunities defined as significant deviations between prices and these fundamental values.
The lure of core value
Adherence to the return of price to fundamental value is a cornerstone of the justification for major investment exposures in our portfolios as well as the belief that value exerts an inexorable pull on price over the medium term. Fundamental value is a discounted cash flow concept for markets and a relative purchasing power parity concept for currencies. Our team’s evaluation methodology is described in two documents available on request.
We observe that the pull of value over price is at least as powerful for currencies as it is for assets, meaning attractive fundamental opportunities can be identified and exploited within currencies in our view. While this conclusion is backed by rigorous academic research, it goes against the consensus of many investment professionals who are often skeptical of the ability to add value by investing in currencies.
In our recent white paper, we summarize our findings that currencies have just as robust a return to fundamentals as markets. We performed simple tests on 19 currencies (18 exchange rates), 14 national equity markets (treating the Eurozone as one market) and four government bond markets. We used monthly data from mid-1971 to mid-2021 (50 years) when available or as much data as possible when not.
Generally speaking, we have found that the time it takes for exchange rates to return to fundamental value is equal or shorter for currencies than for assets. As a result, the probability of a return to value, at any time, is as great for exchange rates as it is for equity and bond markets. And if currencies return to fundamental values on horizons similar to those of stocks and bonds, or shorter, we believe that this property of currencies is yet another reason why active currency management should be widely used.
Emerging versus developed markets and currencies
An additional feature of our findings is that the reversion statistics for emerging currencies and stock markets in our dataset are just as compelling as the results for developed currencies and stock markets (emerging bond markets are not included in our dataset).
It is the consensus wisdom (with which we agree) that the inherent risk (volatility) of emerging markets is higher than it is for developed markets, which has implications for the relative sizes of investment exposures that should be taken in emerging markets, given the magnitude of the value/price gap, relative to developed markets.
However, a similar return-to-value efficiency appearing in emerging and developed markets and currencies suggests that the former are on par with the latter when it comes to inclusion in a dynamic management universe. Our team’s investment universe includes several emerging and developed markets and currencies in recognition of this.
In our view, these findings argue for greater confidence in the use of value/price investing signals in dynamic currency management than may be deemed appropriate by the consensus wisdom of global investors.
It is this, coupled with the expectation of low correlation and high diversification benefits of currency management in a global multi-asset portfolio, that is the basis of our team’s longstanding decision to devote a significant portion of the active assets of its multi-asset portfolios to currency risk
Editor’s note: The summary bullet points for this article were added by the editors of Seeking Alpha.