Several ways to invest in FX
Even though currencies are nowadays considered an asset class, investing in currencies is not a straight forward exercise. Simply investing in U.S. dollars or Swiss francs, for example, is not possible; a currency investment requires a second currency to make a pair. In other words, an investor always has exposure to two currencies, for example, investing in the exchange rate movements of the U.S. dollar against the Swiss franc.

Many investors may be familiar with the “carry trade” approach as one way to invest in currencies. The carry trade is also known as forward rate bias, in which an investor borrows money in a low-interest rate currency and invests in a higher yielding currency. The forward rate bias refers to a tendency of high yielding currencies to depreciate less than short-term forward rates in FX markets would imply. Holding positions in high yielding currencies should therefore result in excess returns.

But FX is more than carry trades. Other currency investment strategies include the trend approach, the volatility approach and the value approach.

In the trend approach – also known as momentum – an investor follows the market trend and tries to take advantage of a clear and significant market movement.

The volatility approach describes a systematic trading of price volatility that is implied in derivative prices.

The value approach is based on fundamental analysis where an investor tries to identify significant under- or overvaluations in a currency pair. Empirical studies show that FX markets are bent to diverge considerably from their mean and revert back over time. Companies and investors often use this approach to determine the fair value of a currency. The wide range of users makes it one of the most common FX approaches in practice.

Based on empirical evidence, these four approaches have very low correlations to other asset classes such as equities or bonds but also among each other. Research by PIMCO also shows that some approaches work better in different phases of the economic cycle than others. The combination of the four strategies allows therefore not only diversifying across the four FX approaches but also taking advantage of their relatively better applicability in the course of the economic cycle.

High liquidity and lots of inefficiencies
Investment opportunities for disciplined investors arise in the FX market from inefficiencies inherent in the market. This may surprise at first because the FX market is an interbank market (i.e., most FX trades are done between banks) and thus highly professional. Currencies are traded 24 hours a day in a highly transparent fashion with very narrow spreads between the bid and asking price. All this would indicate that FX markets must also be very efficient. Empirical studies confirm, though, that the opposite is the case.

The main reason for the inefficiency in FX markets is that many market participants trade currencies for reasons other than maximising their profits. For example, a car exporter’s decision to exchange foreign currency against his home currency is driven by the sale of a car abroad and not by the FX market environment. A British tourist will make the timing for his vacation to the U.S. – and hence the buying of U.S. dollar – dependent on weather and job obligations rather than the latest move of the GBP/USD exchange rate. Political aspects also play an important role in FX markets with central bank interventions – sometimes only verbal – seeking to reach or maintain a certain exchange rate. Often, fundamental data cannot explain these stipulated exchange rate levels.

In addition to market participants, some of the models used in currency trading can create inefficiencies. The most common models used to explain the “fair value” of a currency are based on the economic theory of Purchasing Power Parity (PPP). PPP basically explains by how much an exchange rate has to adjust for two currencies to have the same purchasing power. If purchasing power is equal, a good will cost the same amount of money in two different countries when expressed in the same currency. But other models and different calculations exist, so that there is no real consensus on the fair value of a currency. Extensive economic analysis and modelling capabilities can help investors spot when a currency is over- or undervalued.

Risks can be high for non-diversified FX investors
An investor who relies solely on the carry trade, for example, takes on large risks that require deep pockets if the trade goes wrong. For example, a popular carry trade in the mid-1990s involved borrowing in Japanese yen and investing in the U.S. dollar. However, over the course of just one week in October 1998, the yen appreciated by 14% against the US dollar and more than 8% against the Australian dollar. Depending on when an investor entered the trade, heavy losses resulted. Many investors exited the market after this experience. This was one of the reasons why carry trades saw very limited use for years and why they require extensive risk management.

To make the best use of the available investment opportunities and to reduce the risks in FX investing, PIMCO designed a diversified approach that is new in this asset class. In one step, an investor can reduce volatility and improve the risk/return profile, which makes the strategy more efficient.

PIMCO’s Diversified Approach to FX Investing
PIMCO’s FX approach is based on the hallmarks of a PIMCO product: creating stable long-term outperformance in an uncorrelated way with an advantageous risk/return profile. An integral part is diversification. PIMCO’s approach to the FX markets seeks diversification in two ways: by combining the four currency strategies and by combining different currency pairs. Let us look at diversification through currency approaches first.

PIMCO’s back-tests showed that diversifying across currency strategies provides better results long-term than relying on a single approach because the diversification reduced the impact of exchange rate fluctuations. Combining the four currency strategies also provides a good capital allocation model for currency investments. Let’s assume that the carry approach recommends going short the yen. The value approach however suggests that the yen is undervalued and an investor should go long, while the trend approach points to a sideways move of the yen.

This seemingly “contradictory” signal gives a valuable indication to investors that they should not allocate too much exposure to yen. Only when more and more approaches point in the same direction should an investor consider increasing the yen exposure. Using a model that dynamically adjusts the weighting of a currency approach over the course of the economic cycle, PIMCO’s currency approach uses the different suitability of the strategies to the best advantage of investors, thus systematically extracting alpha.

A risk of concentration persists if currencies are only considered against one single reference currency like the U.S. dollar. In the above example of the USD/JPY carry trade, an investor would have faired better if his yen exposure had been spread over other currency pairs as well. Taking the eight most liquid currencies – U.S., Canadian and Australian dollar, yen, British pound, euro, Swiss franc and Swedish krona – would still allow for only seven currency pairs to invest in. At PIMCO, we play each currency against all others, which allows diversification across 28 currency pairs.

Bringing strategies and currencies together
Combining the diversification possibilities presented by the four investment approaches and the 28 currency pairs allows PIMCO to refine its currency investment approach even further. The weighting in the currency and the different pairs can be adjusted, based on signals from the four strategies. Netting out allocations into the currency pairs improves asset allocation and reduces capital at risk. Thus the approach not only offers benefits from diversification such as lower volatility but also improves the risk/return profile, which can make for an interesting, uncorrelated addition to any portfolio. 

Such a dynamic, multi-factor strategy is relatively cheap to implement despite it being a very sophisticated approach. The high liquidity of the FX market and the low cost of trading remove constraints encountered in some other asset classes and make currencies an interesting asset class from a cost perspective.

Conclusion
The global FX markets, though highly liquid, show many inefficiencies that offer opportunities to prudent investors. The opportunities stem from the varied motivations of FX market participants and the different opinions on the “fair value” of a currency; meanwhile, market size and liquidity make it relatively easy to execute trades quickly. A systematic FX strategy, that seeks to capture value across multiple currency and style dimensions, can generate consistent excess returns. Diversification improves the risk profile of the strategy, whose returns are uncorrelated with other asset classes like equities or bonds. This allows investors to move up the efficient frontier by adding a new asset class to their existing portfolio mix.