Investment beliefs: What are potential drivers of currency returns?

Russell’s head of currency strategies, Mike DuCharme, recently wrote a blog post about potential drivers of currency returns and how that plays into Russell’s investment beliefs. You can read the full post below or on the Russell Blog. Beliefs can be a powerful force. Some people may go as far as to believe that certain phases of the moon result in surging crime rates, emergency room visits or even the unexpected appearance of the odd werewolf. Granted, firm links between the moon and other external events are fuzzy at best, but for some, the beliefs persist. In the investment arena, Russell anchors its multi-asset discipline with a set of beliefs that are far from fuzzy. No supernatural forces at work here! Our beliefs affect how we interact with clients; they shape our active-management philosophy when it comes to markets and the need to achieve investment outcomes. For example, we believe certain investment factors can help to enhance returns and manage risks in traditional asset classes such as stocks and bonds, and even in the less traditional areas such as commodities and currencies. I’ve written recently about currency markets, discussing how changes in exchange rates have wide ranging effects on tourism, imports, exports, and investment outcomes. While I stopped short of werewolves, I also connected currency to defensive strategies that help investors deal with a stronger U.S. dollar, and to proactive strategies that help investors go on the offense with currency markets. All of this guidance is grounded in Russell’s belief in three factors as potential drivers of currency returns,and our belief that investors can benefit from these factors:

• Carry trading occurs when investors seek to benefit from the difference in interest rates between two countries. For example, a currency investor might try to take advantage of the “carry trade” by selling low-yielding U.S. dollars and buying higher-yielding New Zealand dollars, pocketing the difference between the interest rates.
• Value trading involves buying or selling currencies depending on whether they’re over- or undervalued compared to a benchmark.One well known currency value benchmark is The Economist’s Big Mac index, a fun guide that illustrates purchasing power in various markets. The idea is that a McDonald’s Big Mac™ hamburger should cost the same no matter where it’s purchased. In theory, if the cost of a Big Mac differs in two different countries, the exchange rate will move so that the burger’s cost will be the same. Using this theory of purchasing power parity, an investor could sell an overvalued currency and buy an undervalued currency, and wait (hope!) for the currencies to move in the desired directions.
• Trend trading might be better suited for investors who find the Big Mac concept too much to consume. Trend involves buying and selling currencies based on recent price moves.An investor might buy a currency that’s moving aggressively up in price and sell a currency that’s doing the same in the other direction.

While our belief in these currency factors is firm, we also recognize the unpredictable nature of the market. We don’t regard any of our investment beliefs as absolute truths, but rather as effective starting points for developing investment strategy. In fact, we regularly challenge our own beliefs to see if the underlying premises still hold true, and then adjust the beliefs when new evidence becomes apparent. So, whether you believe in the phases of the moon influencing human behavior or watching the relative price of fast-food hamburgers, it’s always important to keep an open mind. And it’s important to recognize both the importance and the inherent limitations of any investment belief set.