However, that need not be the case. Indeed, after taking leverage out of the picture investors will find in foreign exchange a compelling longer-term investment vehicle and a compelling asset for portfolio diversification.
Before considering this proposition in detail, let’s first establish why greater diversification ought to be desirable for Australian investors. Using a self-managed super fund (SMSF) allocation as a benchmark example, recent data from the Australian Taxation Office (ATO) reveal this picture:
. 33.4 per cent allocated to shares (33.1 per cent domestic, 0.3 per cent international)
. 29 per cent to cash and term deposits
. 15 per cent to property
. 13 per cent to trusts (4.2 per cent listed, 8.8 per cent unlisted)
. 9.6 per cent to various “other” assets (derivatives, debt, artwork, etc.)
At first glance, this may appear reasonably diversified, but a closer analysis reveals that the heavy concentration on domestic shares, property and money market instruments is indeed problematic. Two of the three sectors have looked disappointing recently. The Australian Bureau of Statistics reports that its overall House Price Index topped in mid-2010. Meanwhile, the Reserve Bank of Australia resumed cutting interest rates, trimming 175 basis points off the benchmark lending rate since September 2011 and thereby reducing money market returns.
That leaves shares, which have done relatively well since the global financial crisis. Indeed, the benchmark S&P/ASX 200 index has recovered more than half of the losses sustained since the early-crisis peak in October 2007. However, with more than 63 per cent of the S&P/ASX 200 accounted for by financial and materials companies, the opportunities for diversification are limited. That means a typical investor’s fortunes can be made or broken by an adverse development in a single industry.
Furthermore, financials are still dangerously vulnerable to negative knock-on effects from the eurozone debt crisis and materials companies have to contend with slowing demand from China – their largest customer – as manufacturing activity in the Asian giant slows, having peaked in late 2009.
With that in mind, let us consider diversification opportunities offered by the foreign exchange market. The forces guiding exchange rates are relatively simple to identify and track, with prices primarily responding to overall trends in market-wide sentiment and central bank interest rates. This offers Australian investors a far broader range of opportunities than they are currently taking advantage of.
Furthermore, with only seven major currencies to follow, getting a handle on broad-based trends can be far less taxing than pinning down the health and future prospects of publicly-traded companies.
Sentiment trends determine whether investors are focused on achieving the largest possible return, meaning currencies with the highest yields are attractive, or capital preservation, meaning they are enticed by abundant liquidity and low inflation.
Interest rates are a function of a given country or region’s economic growth outlook, where tracking the relevant information comes down to monitoring a handful of economic data releases typically published on a fixed schedule as well as paying attention to statements from relevant central bank and government officials.
Recent moves in the Japanese yen offer a simple example of this dynamic. On 14 November 2012, Japan’s then-premier, Yoshihiko Noda, said he would dissolve the Diet (the country’s legislature), paving the way for an election. Poor poll numbers for Noda’s DPJ party suggested the election would favour the rival LDP and its leader – Shinzo Abe – would be the next prime minister.
Mr Abe, a vocal proponent of intensifying efforts to end deflation, signalled he would use his position to push the Bank of Japan (BOJ) to aggressively loosen monetary policy. The yen responded as traders slashed yield expectations, sliding close to 20 per cent over the subsequent months while Abe moved through the election to taking office and – most recently – installing a hand-picked group of like-minded economists at the helm of the BOJ.
As for the issue of volatility, a closer analysis reveals that FX does not live up to its unfortunate image. Currencies are actually the most liquid financial asset worldwide, with close to US$4 trillion changing hands daily. That makes for a market that is far less volatile than rumours might suggest.
Comparing the world’s most liquid stock – Apple Inc – with the most liquid FX instrument – the euro versus US dollar exchange rate (EUR/USD) – is quite telling. For Apple, the largest daily change in price over the past 10 years has been 17.9 per cent; the average over the same period is 1.73 per cent. Weigh that against the EUR/USD, where the largest daily move was 3.53 per cent, and the average is 0.5 per cent.
With this in mind, the true source of perceived volatility comes from the abundant leverage available for FX traders, allowing them to control a position that is 25 to 50 times bigger than their real-money investment. That can dramatically amplify the effect of otherwise small per cent change moves on the investors’ bottom line, both positively and negatively.
The use of leverage is optional, however, and a long-term investor need not use more than 3 to 4x gearing to mirror the volatility seen in major equities – or any at all.
Having eliminated drawbacks that need not be attributed to FX, such as an inherent bias toward short-term holding periods and leverage-fuelled volatility, one is left with a more objective perspective to consider FX as a longer-term investment proposition.
With a basic grip on the outlook for global economic growth trends and interest rates, investors can tap into a straight-forward channel for much-needed portfolio diversification.
Ilya Spivak is a currency strategist with DailyFX.com, a service provided by FXCM Inc, a global online provider of forex trading and related services to retail and institutional customers worldwide.
