Preface: See part 1 first, as part 2 relies on definitions & discussions from that article:
Although they’re a somewhat misunderstood and underutilized investment, currencies may be a beneficial portfolio diversifier in an environment of low long-term returns for traditional asset classes (see Six Charts Worth Remembering). A currency gives one flexibility that illiquid investments (a house, collectibles, certain hedge funds, etc.) can not match. Currency’s liquidity-benefit occurs when an illiquid investment is unable to be quickly and easily exchanged to pay a debt or acquire a different real wealth item; the illiquidity may be due to investment restrictions preventing withdrawal (in the case of some hedge funds) or because one may be subject to sell the illiquid investment at the current market price (which may be drastically lower in a panic) — or even further still, there may not be a market at all (i.e. no existing buyers).
Although not without its own set of risks, a liquid alternative investment with an absolute return currency strategy (example: a mutual fund that invests in currencies) may be one of the most transparent and liquid investments available to investors due to the very nature of currencies: liquidity.
Passive Investment Concerns — Currencies Move in Relation to Each Other
It’s important to keep in mind that because currencies are merely a method of exchange between real wealth items (see Fundamental Wealth), investing in one currency — or a group of currencies — in a passive (i.e. static or unchanging) portfolio over a long time-horizon is unlikely to produce returns because currencies move in relation to each other; to illustrate this point, a quote from Lakshman Achuthan, co-founder of the Economic Cycle Research Institute, “currency depreciation for one set of economies automatically results in currency appreciation for the others”.* As prices for one group of currencies move down the prices of all the remaining currencies move up by the same amount that the others moved down — just like two individuals on a seesaw.
Absolute Return Currencies
The “seesaw effect” is the very reason why absolute return currency strategies typically use active management — the portfolio of currencies that the fund holds changes over time and both long and short investment methods are used (long currencies that they expect to move up in price and short those that they expect to move down in price).
When contemplating how to use an absolute return currency strategy in an investment portfolio, consider it a volatility diversifier: the absolute return currency strategy is volatile, yet its volatility pattern does not line up with traditional risk-oriented assets (i.e. stocks and credit-sensitive bonds); one can think of each as traveling down its own unique winding path. So while stocks or bonds might be moving in one direction, currencies might be moving in the opposite direction, or not at all; they’re uncorrelated — an attribute of interest for those looking for diversification or unique investment styles.
To take a deeper look at the cause of the lack-of-correlation between absolute return currency strategies and traditional asset classes, one need only look to the fact that they draw their returns from somewhat unrelated events. For absolute return currency strategies, the holdings of the portfolio are often determined based on how currencies are expected to move when supply and demand changes occur due to various influencers: economic growth trends, investment-risk appetite, and market liquidity, among other influencers. It’s the persistent and predictable way that market participants respond to these influencers that creates the potential for returns and diversification — even when returns are scarce for traditional asset classes.
* Quote from the article Amid Structural Lowflation, World Exports Decline