You would like to increase your emerging market exposure but you need a simple and effective way to invest. You like the security and accessibility of cash but you need an average rate of return better than what Treasuries can return in this zero interest rate environment. You love the growth in your equity portfolio but need access to uncorrelated returns when things turn south. The foreign exchange market, or forex, answers many of those needs and is the largest financial marketplace in the world.
For decades the forex market has been known as the market that determines exchange rates. In other words, the buying of one currency and selling of another as an efficient means of determining supply and demand. With central banks around the world granting only limited access, forex investments were difficult to access for everyday investors. This has changed dramatically. What was once a market dominated by major banks and investment firms is now the largest trading and investing community in the world.
Here are 10 reasons why forex investing is an important part of any portfolio.
Despite the low 0.12% rate of return that many money market funds provide, cash has remained the center of the universe for many investors who seek the security of the dollar. A study conducted by Bankrate in July 2013, showed that more than 25% of Americans stash their money under the metaphorical mattress (see “Is cash king?” right). Alternatives exist. Investing in the FX market allows you to maintain the security of cash while potentially benefiting from higher interest rates provided by other countries’ central banks. This can be done by the investor through a self-directed account and a little financial education, a broker-assisted account or a managed account through an investment with a commodity trading advisor (CTA) who specializes in FX trading.
With the interbank forex market capturing approximately 95% of the almost $5 trillion traded in G10 currencies, it provides the liquidity needed to execute trades seamlessly (see “Rivers of liquidity,” right). This means that traders are seldom caught in positions that they cannot liquidate. While providing the volatility and price action sought by traders and money managers, it is this ability to seamlessly exit positions that make the forex market stand out. Higher volume also has the tendency to translate into lower transaction costs, ultimately amounting to higher returns for market participants.
Congress passed legislation in 2000 and 2008 requiring firms acting as counterparties to retail forex transactions, as well as forex pool operators, CTAs and introducing brokers to register with the Commodity Futures Trading Commission (CFTC) and become members of National Futures Association (NFA), the self-regulatory organization for the U.S. derivatives industry. While there are good and bad sheep in any market, the forex space has had greater problems due to a lack of oversight in the past but now has greater supervision.
FX traders, whether in futures or the spot market have visibility into their account at all times. Whether they maintain accounts in their own name, at a bank or futures commission merchant (FCM), the underlying structure is the same.
5. Market access
If there is a bank open in the world, chances are the forex market is open. It is a large, growing and liquid financial market that operates 24 hours a day, five days a week. It is not a market in the traditional sense because there is no central trading location or exchange. Most of the trading is conducted through electronic trading networks, permitting market participants to react to economic events and currency movements.
FX trading allows for the use of leverage of up to 50-1, meaning that you have the ability to control a large amount of one currency using a small percentage of its true value. While the use of leverage is a double-edged sword that can work against you as easily as it can work for you, it creates greater opportunity to profit when used prudently.
7. Carry trading
FX transactions are quoted in pairs because you are buying one currency while selling another. The first currency quoted is the base currency and the second currency is the quote currency. The price, or rate, that is quoted is the amount of the second currency required to purchase one unit of the first currency. When holding an FX position you earn interest on the currency you hold vs. the other currency in the trade. To put on a carry trade, you buy the high interest currency against a low interest one. For each day that you hold the trade, you earn the interest difference between the two currencies.
8. No fixed contract size
While currencies can be traded on an exchange as a future, retail customers also have access to a thriving off-exchange over-the-counter (OTC) FX market. Access to the OTC market has key benefits, including the lack of set order sizes.
9. No commission fees
There should be no transaction fees beyond paying the cost of establishing the spread. While this can be more than commissions on futures, most FX accounts trade without commission and there are no exchange fees or data licenses. The cost of trading is the spread between the buy price and the sell price. This does not change the fact, however, that there are no rules about how a dealer charges a customer for the services provided or the amount that may be charged, should you choose to use a dealer. Dealers who are regulated by NFA must disclose their charges to retail customers, so be sure to check with your dealer before opening an account exactly how you will be charged for your trades because it can work out to be higher. You should pay no more than two pips on majors.
10. Ability to find talent
When Congress required firms acting as counterparties to retail FX transactions, as well as FX pool operators, CTAs and IBs, to register with the CFTC and become members of NFA, it took an important step in safeguarding the integrity of the FX marketplace. Before this legislation was in place, the FX market attracted unqualified individuals seeking customer funds, given the lure of the largest actively traded market in the world (measured not only in terms of market breadth but also in terms of the number of participants).
Years ago traders would post outlandish returns on the Internet and attract investors. Perhaps most crucially, NFA registration requirement means that potential investors can look up any counterparty on the NFA’s website and conduct a simplified background check through the NFA’s “Background Affiliation Status Information Center.” This search will reveal key information, including former employers, disciplinary history and involvement in NFA arbitration cases.
It is best to only work with NFA-registered firms and individuals who can give you access to their audited trade history and disclosure documents.
Gone are the days where the forex space was the exclusive dominion of big banks and major investment firms. Retail customers now have access to this marketplace that provides investors with important diversification, market exposure and significant levels of liquidity. While the exact size of an allocation should depend on a number of factors, including risk appetite, it is generally advisable to allocate 10% to 20% to alternatives including forex. Whether your goal is to execute a carry trade to lock in interest rate income or an allocation to a CTA, investing in forex is certainly something that you should consider.
Christopher Gersch is founder and Director of Portfolio Management at Altimus Capital LLC, a Chicago-based hedge fund specializing in algorithmic trading. He previously was Director of FX at RCM Asset Management.