Long Term Investing in Currencies

Currencies are not financial instruments which typically come to mind when talking about long term investments. Vast majority of financial advisors suggests a mix of bonds and stocks to their clients, with some cash investments, like money market funds or CD's thrown into the mix. Such is long standing, conventional wisdom regarding regarding allocating money for a long haul and is almost universally practised on "main street". The only difference is specific split among these asset groups, in most cases related to the age of person. Virtually all other forms of investments are considered "derivatives" and not suitable for most people.

These views have been slowly changing over last few years, if not decades. Explosion of hedge funds have brought alte
ative forms of investments, other than stocks and bonds, into a vernacular of most individual investors. Today just about everybody with any interest in financial markets knows, at least in principle, what options, futures and commodities are. More and more often these groups of securities are mentioned as separate asset classes with a place of its own in a carefully balanced investment portfolio. Same goes for currencies.

Popularity of spot Forex trading proves that currencies are great trading instruments. Brokers report record numbers of accounts opening every year, trading volumes keep rising and the most liquid markets in the world are becoming even deeper. This is easily noticed when spreads from just few years ago are compared to ones today. In many cases they were cut by half, clearly outcome of increased activity as well as competition for clients among Forex brokers.

One of the characteristics of currencies often talked about is the presence of unusually long and persistent trends. They often last months and years and are the main reason behind inclusion of them into main asset classes. But really, are currencies the kind of financial instrument that could be put away for an indeterminate period of time without more or less active portfolio management? Long term chart of any one currency pair indeed reveals long term trends, but how does it look like on bases of currency baskets, something that would have to be done in order to minimize risks of any one currency exposure? Things get a little different than.

This is a chart of how major currencies performed against a basket of peers since 1970. It was compiled and published recently by Financial Times (www.ft.com). Rates used were trade-weighted exchange: "showing the value of a country's currency in relation to the currencies of a group of countries with which it trades. In the index, each country's currency is given an importance in relation to the amount of trade it does". Another way of valuing currencies is by using Purchasing Power Parity Index. Using trade-weighted exchange we can see which currencies outperformed, or underperformed, based n the same criteria. This chart is a little crowded, but individual currencies can be isolated.

The best performing currency over the period, as measured using trade-weighted exchange, has bee
Swiss Franc. From 1970 to about 1995 it has just about doubled in relation to all other currencies included here. Since than, however, CHF has been declining slightly. One could generously call it a sideways move. All told, over almost 40 years time span this currency gained about 80% against a basket of currencies of its major trading partners. These are not stellar results, especially considering that last 15 or so years produced a net loss.

The US Dollar has been falling in value but not as dramatically as one could have thought. As a matter of fact USD had couple of prolonged periods of appreciation, lasting years. Over the span covered by data one could even call the Dollar a non-performing, or slightly under-performing. However, it was not a currency that should have been a choice for anybody looking for long term gains.

One more currency which has been in the news a lot lately, Australian Dollar. Here also results are rather disappointing. Even at the height of commodities induced appreciation of this decade, AUD was only about 40% higher in value against other currencies that at the beginning of this data series, in 1970. Also not the kind of performance one would expect after four decades.

This table doesn't include many other variables, which would have profound effect on total asset return during this time. Interest rates collected on any one of the currencies would have boosted final results dramatically. Any compounding of these gains is also not included. However, it seems that prolonged trends, one of the most appealing factors for currencies investors, can also be worst enemies when simple buy and hold approach is used. Currency of choice can be on the loosing side of market swing for years or even decades.

What is the answer? Are currencies a suitable asset class for long term investment? Probably not for the static buy and hold approach, long favored with stocks and bonds. While finer points are always debatable and open to discussion, some level of activity would be necessary in order to take advantage of both currency appreciation and interest rate earning potential. It does not mean daily, but once every few months analysis and necessary adjustments should be done. That way individual currencies could be held for long periods of time. Just not in a "set and forget" manner.

Mike K.
www.fxmadness.com