With the rise of accessible international travel, the idea of “trading” or exchanging currencies is not a foreign concept to grasp. Those of us fortunate enough to be heading overseas on holiday will engage in such “trading” by buying other currencies with Sterling – and getting a better or worse rate based on the relative strength of Sterling on that day. Whilst our decision of where or when to go away may not be closely linked to the currency markets, these do at times have an impact; for example, those ’savvy shoppers’ we mentioned last month who, on the back of a strong Sterling/US Dollar exchange rate, headed to the US to stock up on Christmas presents.

However, in most cases the weather or proximity to the beach are more important in our decision making and we buy currency based on when we need it rather than when the rates are favourable. This is one of the contributors to an inefficient and liquid market – unlike in the equity or bond markets, many market participants aren’t focussed on achieving the best rates.

Not all in it to win it

This is also true of other participants in the currency markets, including central banks who trade currencies to rebalance and diversify their reserves or businesses, who import and export goods and services across borders. Not everyone is looking to maximise profit and this means that by their nature, currency markets are not economically efficient. Fund managers, the profit seekers of the group, aim to seek out these inefficiencies and with the objective of exploiting them to generate excess returns.

In addition to their inherent inefficiency, currency markets have some other very attractive characteristics, which lend themselves to active management:

• Low Correlation to other asset classes: currencies move relatively independently of shifts in the equity and bond markets and therefore have the potential to generate returns when these markets struggle
• Low trading costs: currencies can be traded at a fraction of the costs in equity and bond markets
• Deep and Liquid market: the most liquid asset class with daily turnovers far greater than those of equity and bond markets. You can therefore enter and exit positions without materially shifting the market.

Many portfolio managers undertake analysis to find out which currencies are overvalued and which undervalued, similar to how an Equity manager considers a portfolio of stocks. The Economist’s ‘Big Mac index’ – which compares the cost of a ‘Big Mac’ burger across different countries - can be used as an indicator of whether a currency is appreciating or depreciating over time. If a Big Mac in New York costs $1 and £2 in London and then, the next month it still costs $1 in New York but £2.10 in London, this would suggest that the US dollar is weakening and the pound has strengthened.

If this trend was consistent it might be a buy signal for US dollars and a sell sign for pounds as, based on the above philosophy, currencies which are undervalued should be bought and currencies which are overvalued should be sold.

Expanding opportunities

Just as MacDonalds has expanded globally, so has the universe of investible currencies. Recently there has been a growing trend towards incorporating emerging market currencies into a well diversified portfolio.

Though these markets tend to be less deep and liquid, given their attractive yields and positive long term growth prospects, they have the potential to generate significant returns for investors. Investors who cast their net wide in this inefficient market can potentially benefit from the broadest opportunity set.