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Written by Dave Nadig, Matt Hougan and Lara Crigger
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Tuesday, 20 October 2009 00:00 | Related ETFs:
BZF / DBV / EFA / FXA / FXE / FXY / ICI
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Page 1 of 12
 International currency is the largest and most liquid asset class in the world. And yet, most investors have zero direct exposure to currency in their portfolios.
This massive discrepancy exists largely because of currency’s history as an institutional asset. Most currency trades take place either in the highly leveraged futures market or in institution-only over-the-counter arrangements—in either case, markets where most retail investors and financial advisers are (rightfully) afraid to tread.
Over the past few years, however, exchange-traded funds and exchange-traded notes have opened up the currency market to sophisticated retail investors and financial advisers for the first time. Now, buying currency exposure is as easy as buying stocks.
Still, the integration of currency into investor portfolios has been slow. One primary reason is simply a knowledge gap. While most investors and researchers understand the role that equities, bonds and even commodities play in a portfolio, currencies remain a mystery. Despite the size of the market, there isn’t yet a significant body of academic research exploring the strategic role currency exposure can play—certainly nothing on the scale of the volumes of research dedicated to equities and bonds.
This paper aims to start to fill that gap, exploring on a concrete level the impact that currency exposure has on portfolio returns.
The paper begins by offering a brief outline of how the currency market functions, and examining the major strategic drivers of currency returns. It then examines the role of currency as a stand-alone asset class for strategic as well as tactical investors, and considers how adding currency exposure to a portfolio can increase its risk-adjusted returns.
It also looks at the historical argument for adding international equity and fixed-income exposure to a portfolio, and examines how much of the diversification benefit these investments achieve is driven by the underlying currency returns.
Finally, the paper discusses the growing tools available to investors seeking access to the currency space, and the various ways these can be integrated within a portfolio.
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