The Rise of Retail Foreign Exchange

Posted 06/05/2009, 9:00 am EST by Betsy Waters from tradingmarkets.com

Investing in the foreign exchange (FX) used to be the exclusive preserve of an elite group of hedge funds, investment banks and multinational corporations. These institutions guarded their turf fiercely and no wonder. Between 1990 and 2006, FX investments returned 9% a year, more than either bonds or equities over the same period.

But for individual investors, the FX market has been effectively off-limits: minimum trades were as much as $1 million, and there were a myriad of complex legal documents to review and sign, as well as extensive credit checks that were required before a bank would consider trading with you.

Over the past ten years or so this has all changed. Thanks to the advent and growth of the Internet, online trading systems – which give ordinary investors direct access to the currency markets - it is now possible for the retail investment community to easily and quickly trade on the international FX markets from any internet capable PC.

And investors don't have to have large sums of capital to get involved. It is possible to set up an account and start trading with an initial investment of as little as $5000.

Crucially, individuals can also now obtain all the data they need to trade FX at negligible cost and are able to trade at the same speed as banks and hedge funds using this platform. They are able to get streaming real-time executable prices and access to up-to-the-minute research to help ensure they have sufficient information they need to make an educated and sound investment decision.

But the question does arise; why should investors look to FX as an asset class, and how can currency add value to an investment portfolio?

One of the most important reasons to consider investing in FX is that it has a track record of generating positive returns on a consistent basis. Research conducted by Deutsche Bank shows that FX Investments returned 11 per cent a year on an annualized basis between 1980 and 2006 with 21 positive returns and five negative return years.

In addition, unlike individual bonds and shares, FX returns are not directly correlated to the world's equity markets and fixed income markets. As most investors know stocks or stock indices, even when varied by country or industry, tend to move in synch. This may become increasingly important in the months and years to come if, as some people believe, the world economy slows and the value of traditional assets such as shares and property falls. Of course, FX is not the only asset class to offer this benefit: commodities and private equity funds also offer the same "diversification" benefits, but FX is probably the least well known of the three.

It also has an unusual dynamic not shared by other asset classes, namely that a significant proportion of its trades are executed to hedge risks and not to generate profits. These two characteristics create regular trading opportunities for investors who have the technology to keep in touch with market-changing events and react to them.

In terms of trading strategies in the currency markets the three most widely known are the carry trade, valuation trade and momentum trade.

Of the three, the carry trade is the most widely known. A carry trade is where an investor borrows low-yielding currencies and buys high-yielding ones. This approach has seen considerable publicity in recent months, with the low interest rate environment in Japan seeing investors borrow Japanese yen and buy higher yielding currencies such as the New Zealand or Australian dollar. While the Japanese housewife is seen as the main instigator of this phenomenon, its practice is considerable wider, and reflects the growth of online/retail FX as an investment opportunity.

While less well known, the momentum and valuation trades are no less important. Currencies appear to trend over time, which suggests to momentum traders that using past prices may be useful when investing in currencies. This is largely due to the existence of irrational traders (such as institutions that are trading FX in order to hedge their positions not to generate an investment profit). Other factors are the possibility that prices provide information about non-fundamental currency determinants or that prices may adjust slowly to new information.

For valuation trades, in the long-run, currencies tend to move back to their fair value based on Purchasing Power Parity (PPP). However, in the short to medium term, currencies can deviate from their PPP values due to trade, information and other costs. This allows traders to potentially profit from currencies as they revert back to their fair values over the long run.

From an asset allocation perspective, investors know that deciding what proportion of risk should be allocated to a given asset class is not a precise science. However, as a generalization, it appears that while adding FX to a portfolio of bonds and equities can increase the average annual returns, the biggest benefit appears to be in reducing volatility of returns and periods of draw downs.

But it is important for investors to remember that in the asset allocation process, returns are not the only criteria; correlation between asset classes is also an important consideration. On that front, recent research has shown that since 1980, equities and bonds have had a 26% correlation in monthly returns. In contrast to this, the correlations of any of the individual FX strategies or the combined one to bonds and equities range from -25% to +7%. In all cases, they are smaller than those between equities and bonds.

This demonstrates that FX has a tendency to be negatively correlated with bonds and marginally positively correlated to equities and can be legitimately considered an important asset allocation tool for investors. It also has the added advantage of direct access to a liquid trading market 24 hours of every business day.