The surge in foreign exchange market volatility has been a headache for some investors but has also highlighted the returns available in this sometimes-ignored asset class.

Record low levels of volatility in currency markets in the period preceding the credit crunch arguably made bankers complacent about currency risk in clients’ portfolios. But as volatility has surged, it has focused attention on managing this risk and how to make money out of it.

Foreign exchange is a huge business. In 2007, the latest year for which comprehensive turnover data are available, average daily volume stood at $3.2 trillion, according to the
Bank for International Settlements in

Basel. Considering that market volatility has risen over the past two years, that figure is almost certainly smaller than today.

There have been some clear-cut recent trends: the Swiss franc, for instance, has appreciated by about 2.7 per cent against the dollar over the last three months; by contrast, the Swedish kronor has dropped by more than 10 per cent against the greenback over the same period. If the investor can get on the right side of such a trade, that is quite a return.

Currency dealing is “very much a forgotten asset class”, says
Phil Cutts, a vice president and director of
RBC Wealth Management. He notes that while most investors have an understanding of their risk tolerance and can take a view about equities, bonds or even hedge funds, this is not always the case for currencies.

“It never ceases to amaze me how many people ignore currency risk,” he told WealthBriefing recently. “The increased volatility we’ve seen in the last 12-18 months has been a wake-up call and clients are more aware of the amount of currency risk they are exposed to,” he said.

The impact of currency movements on private client portfolios is demonstrated by the wide performance differential of Asset Risk Consultants’ Private Client Indices for 2008. Calculated using details of the real performance numbers generated by participating investment managers, the average Sterling Balanced Portfolio (40-60 per cent equities) fell by 12.4 per cent, whereas its Dollar counterpart fell by 26.3 per cent - a gap of 14 per cent.

As performance is calculated in portfolios’ base currencies,
ARC managing director,
Graham Harrison, said that a large degree of the differential was caused by currency movements. Due to the currency’s decline, a sterling investor gained a direct benefit from investing in international assets. However, for a dollar investor, there was no direct benefit of investing internationally to their own currency going up, so they missed out on the gain.

“Sterling denominated portfolios were more volatile than dollar portfolios because of the currency impact, but the currency effect was a positive one,” said Mr Harrison, who argues that if an investor converts performance figures back to the same currency, performance would be similar.

Whereas ordinarily currency is what Mr Harrison calls “a by-product of the asset allocation process”, in 2008 it was one of the main differentiating factors of performance. For example, a sterling investor in a dollar denominated hedge fund might have made a positive return even though the hedge fund was down 15-20 per cent. “Currency exposure is one of the decisions that matters greatly, but is difficult to get right,” Mr Harrison said.

According to Mr Harrison, currency risk is implicit in equity investing. For example, the decision to invest in BP because it makes a lot of its earning in dollars rather than Sainsbury's with a sterling earnings base. Incorporating currency exposure in other asset classes tends to be seen as a braver, more explicit decision – the choice of property exposure in Europe rather than the UK; purchasing a hedge fund denominated in dollars rather than sterling; buying Japanese yen-denominated bonds instead of gilts – yet such decisions made huge relative return differences in 2008.

Thomas Becket, head of global investment strategy at
PSigma, says that sterling weakness, which he describes an “open goal” trade, has been central to his firm’s central investment thesis for the last two years or so.

“Rather than hedging out the financial market risk, we’ve embraced currency risk on behalf of clients by investing in international equities and bonds whose performance has been boosted by the weakness of sterling,” said Mr Becket. He also observes that between 2005-2007, it was “really painful” investing in international equities. “Markets went up and our geographical asset allocation was strong, but returns were tempered because sterling performed so well. Now international equities and bonds are benefiting from weakness in our currency,” he said.

In some cases, especially after recent turbulence in forex markets, PSigma prefers to take on asset class risk rather than currency risk. One recent example is in playing out its tactical views that soft commodities could outperform most other assets through the uncertainty of 2009. In this case, the firm tends to use funds that hedge back out the currency risk back to sterling.

As PSigma’s clients are almost exclusively based in the

UK, Mr Becket does not currently see the value in participating in expensive currency swaps. However, for internationally mobile clients, bespoke management of currency risk is imperative, but often forgotten.

“Today, clients are pretty globally mobile and may have homes in two, three or four countries,” said Mr Cutts from RBC Wealth Management. “Once we have established what the base currency or currencies actually are, we then discuss with clients whether they want to exclude currency risk or whether they want to take the risk.”

As a wealth manager, the first thing he does is to establish the currency under which a client wishes to maximise their wealth, considering factors such as whether they are temporarily abroad and want to return to their home country or whether they are planning to retire abroad. Assessing a client’s currency needs can be far from straightforward.

Take the case of a client living in the

US who wishes to maximise their wealth in dollars. They may well be comfortable with equity risk and want to hold European stocks but will not want to take on the associated currency risk - in this case the euro.

According to Mr Cutts, a significantly higher proportion of his clients want to mitigate currency risk than shoulder it. The simplest strategy to eliminate risk is to use FX rolling forwards on currency pairs.

It is also possible to hedge by buying an option to benefit from the returns on any upside movement but protect a client from losses on the downside. Heightened volatility has increased the cost of options and this type of ‘absolute’ insurance, however. Hedging costs can be cut to between zero and 3 per cent by hedging within a range where a client is prepared to accept limited downside risk at the same time as limiting potential upside. Investors can do this via a put and call option structure where the premium of one purchased option largely offsets the cost of the other.

Looking ahead, in an environment where returns from cash are close to zero and currencies move 10-20 per cent or more in a year, the currency decision is becoming an increasingly important one. “If annual expected returns are sub-10 per cent and you inject currency risk, the volatility of a portfolio can more than double. The danger for sterling investors now is that if the dollar and/or euro reverses against sterling, Sterling portfolios will find currency exposure a curse rather than a cure,” ARC’s Mr Harrison said.

Whichever way currencies move in the coming months, volatility looks set to continue. Investors should not just examine how to minimize any damage to their portfolios but can also boost returns by smart use of the currency market.