Allocation and Currencies?

How long before currencies are widely treated as an asset class? The question is crucial because finding new asset classes -- shortly before institutions begin treating them that way -- can be a very lucrative strategy. (For example, Energy commodities have skyrocketed in part because of institutions beginning to treat them as an asset class in the past five years).

Most institutional money managers and asset allocation advisories don't count currencies as an asset class, in that they don't apportion a percentage of their assets exclusively for currency investments. Currency is still a crucial part of all international investors' considerations, but it's usually not treated as a separate asset class by investors other than globally-oriented hedge funds.

Why not? After all, currencies frequently provide a source of significant alpha and uncorrelated returns. And some investors do extremely well in currency investing. For example, in Inside the House of Money, the manager of a significant family investment fund, Falcon Management, says:

• [F]oreign exchange is a whole area of risk premia that none of the real money [long only] funds are earning.
• Back to the smart real money (long-only] funds, Yale has seven asset categories where they look to extract risk premia and Harvard has eleven. The question is, why doesn't Harvard throw in a twelfth category? They should be looking at other uncorrelated markets such as foreign exchange for more sources of risk premia. Once they identify new sources, they can allocate X% and, in a Markowitz sense, run an efficient frontier to come up with what the correct allocation should be. But they don't do it. Asset categories like foreign exchange or options are not thought of as an asset category where risk premia can be earned.
• As a hedge fund, we'll look anywhere for opportunities. The currency markets are a place where global macro hedge funds especially earn risk premia. I can name three risk premia in currencies that I don't think any real money manager has ever attempted to earn on a systematic basis: (1) High yielding versus lower yielding currencies.... 92) Short-dated volatility is too high because of an insurance premium component in short-dated options....(3) Longer-dated options are priced expensively versus future daily volatility, but cheaply versus the drift in the future spot price....

The Falcon manager, Jim Leitner, notes there's significant value to be extracted from currency markets (indeed many asset classes) over time:

• The large inefficiencies do not get arbitraged out because there's very little capital that actually gets allocated toward extracting value over multiple years. Everybod who's allocating money to hedge funds has monthly or quarterly redemption clauses, which force hedge funds to manage to those liquidity paramaters, and that's not at all the way to wealth.

Things are starting to change, and will probably continue to. The U.S. dollar's precipitous multi-year slide versus other major currencies is forcing more money managers to think about creating asset allocations for currency. Moreover, ETFs tracking currencies are rapidly appearing.

The traditional reason why currency isn't regarded as an asset class is that there's no "expected return." The currencies taken together are a "zero-sum" game, versus other asset classes where everyone can win. But for some investors, active management of currencies are creating consistently strong returns that institutional asset allocators (such as pension funds, insurance companies, charitable organizations, etc) may stop ignoring.