By Jonathan Dagg, portfolio manager at European and Global Advisers
Foreign exchange (FX) markets are among the most liquid in the world, with daily volumes exceeding $6trn.
Yet for many wealth managers, FX remains underutilised as a strategic asset class.
Incorporating FX into a portfolio offers diversification beyond equities and bonds, with returns that exhibit low correlation to traditional assets. This makes it an invaluable tool for improving risk-adjusted performance, particularly during periods of market stress.
Macroeconomic drivers such as interest rate differentials, inflation trends, and geopolitical shifts often create opportunities in FX markets. Unlike equities and bonds, FX is inherently relative – currency valuations fluctuate based on the comparative strength of economies, providing unique opportunities for return.
Historical evidence suggests that strategies such as the FX carry trade, which capitalise on interest rate spreads, have delivered consistent returns, particularly during periods of rate divergence.
By leveraging systematic FX strategies, wealth managers can not only diversify risk but also access a liquid, scalable asset class that dynamically responds to global market conditions. As correlations between equities and bonds shift, the case for integrating FX into portfolio construction has never been stronger.
Portfolio diversification
Systematic FX strategies, while complex, can be built on well-understood principles that exploit inefficiencies in global currency markets. There are four key principles to consider.
The first is that rates often reflect relative economic performance. During the post-2008 recovery, for instance, currencies of commodity-exporting nations such as the Australian dollar (AUD) appreciated significantly as global demand for resources rebounded.
Trends can also be exploited. Momentum-based strategies leverage the persistence of currency trends. Following the Brexit referendum in 2016, the British pound (GBP) experienced prolonged weakness against major currencies, a move that trend-following models could exploit by identifying the relative strength or weakness of individual currencies.
Another factor worth noting is that interest rate carry trades are back. Carry strategies take advantage of interest rate differentials by borrowing in lower-yielding currencies and investing in higher-yielding ones.
From 2012 to 2020, as global interest rates headed towards zero, there was no differential to exploit. However as interest rates have normalised, the interest rate carry trade has returned as an alpha-generating signal.
Risk management can also be relatively straightforward in FX. Incorporating data from FX options markets allows for better anticipation of potential market shocks.
During the 2020 US presidential election, for instance, a spike in implied volatility for EUR/USD options signalled heightened uncertainty.
These strategies can significantly improve the stability and performance of portfolios when systematically implemented, regardless of market conditions.
Crisis mode
Historical examples underscore the value of FX strategies in navigating challenging markets.
During the European debt crisis from 2011 to 2012, systemic risks weakened the euro (EUR) against the US dollar (USD). Macro models incorporating sovereign credit spreads and sentiment indices would have identified sustained opportunities in such trends.
In the COVID-19 crisis, safe-haven currencies like the Japanese yen (JPY) and USD appreciated, while oil-linked currencies like the Canadian dollar (CAD) depreciated sharply, reflecting economic dislocations. These movements highlight FX’s capacity to act as a hedge against global uncertainty.
Quantitative backtests show that adding a 20% allocation to FX strategies to a traditional 60/40 portfolio reduced drawdowns by 15% and improved the Sharpe ratio by 0.3 over a 10-year period.
We do not suggest that it is possible – or desirable – for managers of private client capital to follow this exaggerated level of FX alternatives exposure. But the point stands that there are pragmatic ways to increase the performance of multi-asset portfolios.
True diversification
FX strategies offer wealth managers a powerful toolkit for diversification and enhanced portfolio performance. By integrating systematic FX approaches into broader portfolio frameworks, managers can achieve resilience, scalability, and improved risk-adjusted returns.
As markets evolve, the inclusion of FX is becoming a necessity for robust portfolio construction.
Whilst investing standalone in FX might not be for some, it is important that wealth managers consider how to incorporate the alpha and diversification benefits offered by FX.
It can be a cornerstone of multi-strategy systematic funds, contributing to both diversification and risk-adjusted returns. FX markets are uniquely driven by macroeconomic forces such as interest rate differentials, purchasing power parity (PPP), and global monetary policy, all of which can be systematically exploited.
For instance, some models can evaluate value between any currency pair, independent of USD, delivering a robust approach to capturing relative valuation opportunities.
Additionally, systematic trend-following models can identify momentum in currencies, leveraging the persistence of economic underperformance or strength.
Multi-strategy funds that incorporate systematic FX strategies have been successful in the hedge fund industry for good reason. As more data about the physical and online world is collected, wealth managers will find ever more value in combining uncorrelated strategies to unlock returns in this unique asset class.