It’s more than a side issue, as the good managers will see

Not just a medium of exchange between countries, currency has been shown by recent studies to possess the potential to reduce risk and enhance return when given greater consideration in a well-managed portfolio.

George Bernard Shaw once said that Wagner’s music was much better than it sounded. The same can be said of currency. Why? Rather than seeing currency as a by-product of exposure to overseas asset classes, currency can instead be viewed as a stand-alone asset class with the potential to reduce risk and enhance return at the total portfolio level. And in markets like those we have experienced recently anything that reduces risk and enhances return must be worthy of consideration. The theory In its basic form, currency is a medium of exchange between different countries. The demand for currency itself is driven by cross- border demand for real goods, services and assets. This, in turn, is driven by differences in price levels, quantity of traded goods and expected risk-adjusted return on assets. However, it is interesting to note that the majority of players in this market continue to regard currency management as a side issue to their main objective of buying and selling goods and services. This is good news as an inefficient marketplace is the perfect playground for the active manager. We also believe that the range of economic factors that drive long-term currency returns are different to those driving local equity and bond returns, and hence, suggest a weak relationship between bonds, equities and currency. Empirical evidence lends support to this phenomenon, as highlighted by historically low correlations between currency and traditional asset classes. We also believe that for extended periods of time currencies are affected by the behaviour of market participants whose objectives differ from the “typical” profit maximising investor – examples are central banks and international corporations. Structural barriers, such as capital controls, may also produce behaviour which contradicts classic efficient market hypotheses. The reality Until fairly recently, there was little information on the outperformance potential of active currency managers. However, a number of studies have covered this area recently. Watson Wyatt analysed monthly return and hedge ratio data on over 200 currency overlay accounts from 20 leading currency overlay managers, separating them out into comparable universes. The average cumulative gain since inception was 1.5 per cent – although this varied across account type. Frank Russell Company subsidiary Russell Analytical Services also examined a very large universe of currency overlay mandates, incorporating over 10,000 monthly return observations from 1989 to June 1999. They concluded that the data set provided “sufficient evidence of skill within the universe of managers studied”. The average annual information ratio was 0.46 for all accounts. Our way Goldman Sachs Asset Management has been a practitioner of active currency management for more than 10 years and our experience and deep quantitative resources allow us to construct bespoke risk-adjusted strategies that can supplement existing investment approaches. To give an indication of how we believe currency can add value over the long term, we have set out here results from the Goldman Sachs representative global currency account. The account has generated gross annualised excess returns of 4.10 per cent and, as at 30 June 2002, had a tracking error of 4.13 per cent. Based on monthly data, the historical information ratio (IR) has been 0.99 since inception. Less risk As shown, we believe that the factors that drive currency markets are not strongly correlated with equity and bond markets. An in-house correlation analysis from the global currency account since inception in 1991 to May 2002 shows that the alpha generated from currency has a historically low correlation with other asset classes. To conclude, we think that currency is a viable and attractive separate asset class. A well-managed strategy has the potential to enhance returns and reduce risk and, in contrast to some investment opportunities, currency is a deep, liquid market. Alex Fletcher is European head of third-party distribution at Goldman Sachs Asset Management