For a brief shining moment last summer, the path seemed utterly clear. President Obama and leaders in Congress were battling fiercely over the U.S. debt ceiling, policy makers in Europe were squabbling about how to deal with their own mounting sovereign debt loads and imminent defaults, and major bond raters were threatening to put a credit pox upon all their houses. The political wrangling was driving down the stock market and swinging a wrecking ball across retirement plans everywhere. It was a nail-biting time for tens of millions of people. But to Ian Naismith, such terrible news seemed like pennies from heaven.
Foreign-exchange trading, or "forex," is a game of schadenfreude -- where one country's currency benefits from another nation's economic misfortunes. So Naismith, who began investing in currencies five years ago and runs a fund, Currency Strategies, that had beaten its benchmark by four percentage points the year before (a romp in the forex world), bet heavily on currencies of countries that seemed to be at the peak of fiscal health. Brazil and Australia, for instance, were commodity-rich and sitting on hefty budget surpluses. The Swiss franc, no surprise, also looked rock-solid; it had long stood among the world's most stable currencies. But as the summer wore on, Naismith found himself second-guessing a half-dozen of his biggest calls.
A Day in the Life of the Currency Market
- 12:17 a.m. - Australian dollar rises during Asian trading, ignoring consumer confidence figures that show only a modest uptick.
- 12:45 a.m. - Report says China is likely to ease monetary policy. Euro ticks up against U.S. dollar and yen.
- 4:30 a.m. - Barclays Capital predicts another up day for the pound, just as the December jobs report shows U.K. unemployment at its highest level since 1995.
- 9:53 a.m. - Swiss franc plunges in New York trading, but traders blame human error rather than intervention by the Swiss National Bank. Euro spikes 0.5 percent against the franc a big move by currency-trading standards.
- 10:45 a.m. - India's rupee rises for the fifth straight day, for a nine-week high against U.S. dollar.
- 11:49 a.m. - Chile's peso closes at two-month high versus U.S. dollar on renewed optimism.
- 12:47 p.m. - Mexican peso rallies after IMF says it's "seeking up to $500 billion in additional lending resources" to fight the euro-zone debt crisis.
- 1:04 p.m. - Report says another Greek debt deal may be imminent. Euro closes up 1 percent for the day against the greenback.
- 3:48 p.m. - Canadian dollar posts modest gains, which traders say are linked to bond auctions in Germany and Portugal earlier in the day. New York trading closes 12 minutes later.
By Elizabeth O'Brien and Anna Prior
Just as he was about to pull the trigger on a trade, the dollar, for example, would reverse course. The ceaseless stream of market-rattling headlines -- from America losing its centuries-old triple-A rating to setbacks for China's manufacturing sector -- threw the seeming order of schadenfreude into chaos (which is German, it turns out, for chaos). As policy makers raced to save the euro, the currency fell only modestly, not even approaching its three-year low against the dollar. The "safe haven" Swiss franc, meanwhile, tanked -- not because Switzerland's economic prospects had changed, but because safety seekers were pushing the franc too high. Central bankers around the world intervened, sending the currency tumbling about 10 percent against the dollar -- a jaw-dropping move in a market where investors routinely "double down" on bets by way of leverage.
Naismith's boutique-size $14 million fund, which trades under the apt symbol FOREX, tumbled further in the fall, hitting a low in October. Then another low in November. Ditto in December. "It was a horror story," says Naismith, who finished his roller-coaster year down 3.7 percent. "We just got whipsawed."
So, for that matter, did nearly every other fund manager in the currency game. A few years ago, such Sturm und Drang in the foreign-exchange trade wouldn't be major news to anyone, except for a clique of high-powered bankers, a few dozen hedge funders and any overseas traveler changing large sums of money at the Newark airport currency kiosk; for everyone else, it would be ho-hum. But last year, Main Street investors -- in large part encouraged by their financial advisers -- charged into the currency market in such numbers that one might have assumed they were giving away a free pony with every new account. Investors poured $4.7 billion into currency-related funds in 2011, even as they pulled money by the trunkload from both domestic and foreign stock funds. The daily volume in the currency market, already at a staggering $4 trillion, is expected to more than double by 2020, in part because of interest from smaller traders, according to UBS. And retail investors now account for 8 percent of that volume, notes research firm Aite Group, up from less than 1 percent a decade ago. For a market long dominated by central bankers, corporate treasurers and wealthy speculators, the change, say experts, has been dramatic.
The reasons for this sudden enthusiasm are painted on many a brokerage performance statement. While many investors have been looking at a sea of red in recent years, hedge funds and other institutional forex traders followed by the Iowa-based BarclayHedge research shop have been awash in green. Since 1987, the Barclay Currency Traders index, which tracks such players, has logged only four down years, without a double-digit loss. In contrast, the S&P 500 has been down six times over the same period, with four of those losses exceeding 10 percent. What's more, these consistent, if generally modest, gains have historically come with another, more surprising, selling point: stability. Over the past decade, currencies have actually been half as volatile as stocks and have tended to move in a direction that's largely distinct from the trading patterns of stocks and bonds, according to currency- and bond-trading firm Merk Investments. Indeed, as financial advisers increasingly urge clients to "diversify, diversify, diversify," it has been the latter of these qualities -- an independence from the stock and bond markets -- that has launched the forex frenzy. That and "the fact that nothing else was working," concedes adviser Kenny Landgraf, who heads up Kenjol Capital Management, in Austin. Over the past year and a half of dizzying stock volatility, says Landgraf, currency investing was supposed to be, well, "something else."
And so it is. But therein lies the catch, in fact: Forex investing is something else entirely -- or, make that two something elses. As it turns out, the trading realm in which most retail investors make their bets is far different from that in which the institutional giants roam. The currency names -- euro, yuan, peso, rupee -- may be the same for each, and the same global news may blare endlessly across each domain, but there the similarities end. And the differences in the way trading works for the big and little fish often have a dramatic effect on returns. On average, investors in currency mutual funds lost 3.3 percent in 2011, after fees, according to Morningstar -- a return that trails not only the broad stock market (the S&P 500 was up 2 percent, including dividends), but also professional currency traders (by about the same margin). And 2011 was no fluke: It was the fourth year in a row that currency mutual funds -- where some 70 percent of new retail forex dollars are flowing these days -- did significantly worse than institutional traders, as measured by the BarclayHedge index. An investor who put $10,000 into an average currency mutual fund in 2009 would be down roughly $500 today; had he put the same amount into the average currency hedge fund, he'd have turned a $700 profit -- a striking $1,200 difference.
And as for stability -- that major selling point for the asset class? Lately, it's been illusory. Instead of offering shelter from the stock market's storm, currencies were on the leading edge of a financial hurricane, as the global debt crisis sent the euro reeling and other coins of the realm flying this way and that. (Even in the typically stable Swiss franc, volatility jumped 40 percent above its historical average.) Experts, moreover, say those suddenly rocky trading patterns aren't likely to flatten out soon -- which, for some folks, raises the question: Should investors forget this something else and start looking for another? After all, wild swings and red ink: You can get those in the stock market.
As financial realms go, the forex market is so gargantuan that it's hard to fathom, with $4 trillion worth of trades made every day. That's almost five times the daily volume of the U.S. bond market -- or put another way, a dollar amount in trades rivaling Germany's annual economic output every single day. Even so, the essence of currency trading is fairly simple: In each trade, an investor buys one currency and sells another -- betting that the first will rise in value against its counterpart. Buying "euro/dollar," for example, means one buys a unit of euros and sells the equivalent amount in dollars, profiting if the euro subsequently rises in value against the greenback. A generation ago, investor George Soros famously took that two-step to near mythic proportions, making a reported billion-dollar profit on a heavily leveraged bet against the British pound -- on a single autumn day in 1992. More recently, even in a difficult 2011, a handful of hedge funds logged double-digit gains, according to Hedge Fund Research. Leverage, naturally, can just as easily work to the opposite effect. FX Concepts, one of the world's largest currency hedge funds, lost 17 percent in 2011. (Lead manager John Taylor cites poor timing on his calls, especially around the euro.)
The World vs. the U.S.
Investors looking for stability in the currency markets have gotten anything but that of late. Here's how some prominent foreign currencies have fared against the U.S. dollar over the past few years.
One of the best-performing currencies against the U.S. dollar over the past three years, the Australian dollar is also one of the more volatile, undergoing wide swings in response to global economic headlines.
Despite the Continent's fiscal crisis, the euro held up better than most analysts expected in 2011. But Europe's ills especially concern about a Greek default and trouble in Portugal are catching up to the currency.
In 2011, it had the highest volatility of any major currency. The franc drew a huge influx of investors last year, then suffered a 10 percent one-day decline when the Swiss National Bank acted to drive the price back down.
The real has fallen by 10 percent against the dollar in the past year, as investors have fled emerging markets. But many fund managers still favor it because of Brazil's fast-growing, commodity-rich economy.
After earlier stops and starts, China let the yuan's value float on a limited basis in 2010. Forex.com strategist Brian Dolan expects the yuan to become more popular as China's economy keeps growing.
Even last year's devastating earthquake didn't shake the yen, up 8 percent in the past year. Despite Japan's weak economy, strategists expect cautious investors to favor the yen.
The loonie, as Canadians call it, is closely linked to commodity prices and takes a beating in market panics. But many strategists favor it over the U.S. dollar because Canada is in better fiscal health than its neighbor.
Value of currencies in U.S. dollars, with their highs and lows for the period 12/30/07 through 12/30/11.
SOURCES: Bloomberg; Forex.com; Merk Investments
Few individual investors, of course, are giving Soros a run for his money, but a small share -- particularly those who have used exchange-traded funds to access the currency markets -- have done remarkably well in recent years. While exchange-traded funds that were focused on currency bets trailed the BarclayHedge index in 2011, losing just over 2 percent, those ETFs actually beat the pros in the preceding two years, by two percentage points in 2010 and by a whopping eight points in 2009. (In 2009 and 2010, explains Terry Tian, currency analyst at Morningstar, ETF investors rode two currencies in particular, the Brazilian real and the Australian dollar, to big heights as the U.S. dollar fell in return -- a bet that was dead wrong in 2011.)
But truth be told, the spikes in currency ETFs, which account for a small share of forex trading, have been pretty much the only upbeat story for individual investors in this realm. For their part, veteran traders say retail currency investors are unlikely to beat or even match the performance of hedge fund managers over the long term -- for the simple reason that the latter have more tools at their disposal to pick timely bets and can make far more on each bet in the process. That is to say, the big boys can use an abundance of leverage in their trading, something currency mutual funds don't (and frankly, can't) use. And then there is the matter of portfolio size: "The retail forex investor is like the short stack in poker," says Brown Brothers Harriman currency strategist Mark Chandler. "They are undercapitalized and can't absorb the volatility as well." Now throw in the fact that many retail funds limit themselves to trades based on the dollar -- whereas some of the better currency-trading opportunities in a given day or month may not involve the dollar at all, says Brian Dolan, chief currency strategist for online retail trading platform Forex.com. For investors concerned about the future prospects of the euro as well as the dollar, for example, better options might include selling the euro and buying the Australian dollar or Norwegian krone. "You are suffering from a limited buffet with just three to four dishes," says Dolan. "In the spot market, you have the full smorgasbord."
You don't have to tell that to Alessio de Longis. The manager of the Oppenheimer Currency Opportunities fund understands full well the limitations forex mutual funds face. His portfolio, for instance, is geared to those who want to short the dollar, a strategy that doesn't work well in any year when the greenback is strong -- which largely explains why the fund was down 4 percent in 2011. (De Longis also blames the volatility created by the magnitude of market shocks.) But the portfolio's very design, he says, makes the comparison with hedge funds unfair: "It's like comparing the S&P 500 to a long short fund," he says. "Apples to oranges."
Such distinctions, though, are rarely clear to investors -- especially when they're getting the forex pitch from an adviser newly returned from the latest financial industry confab or seminar. Increasingly, such conferences have been packing in training sessions on currency trading, says J.J. Burns, of investment advisory firm J.J. Burns & Co. But rarely do those meetings stress how uneven the playing field can be -- or highlight what many experts now say is a new era of heightened volatility. "The fund companies are on an overdrive kick to sell alternative investments," says adviser Kevin Kautzmann, president of EBNY Financial in New York City, who began getting calls from firms pitching forex offerings last year. The currency mutual funds and ETFs, he says, are the latest fashion frenzy -- following gold (two years ago) and real estate investment trusts (three years before that). "It seems they start pushing it when the asset class starts to peak," Kautzmann says.
Indeed, the biggest concern about currency trading -- too much risk for too little reward -- is making some advisers who thought well of this asset class start to rethink their position. "It's been just too tough to pick the battles" in a global financial market, says Jim Holtzman, of Legend Financial Advisors, in Pittsburgh, who has recently reduced his clients' currency exposure. Financial planner Jason Jenkins, CEO of Assetwise Investments, has reached the same conclusion. Trying to predict the currency markets is "taking the crystal ball to a whole new level," he says. "Even the smartest people get it dead wrong."
There is, of course, a whollydifferent way to play the currency market, say some investors, and that is the DIY approach. That has been the strategy of Jasmine Wang, who is part of a growing army of forex day traders -- a group experts say is most responsible for pushing retail currency trading volumes to more than $310 billion in 2011, up from just $6 billion in 2001. Instead of trying to read the tea leaves of central bank reports and parse reams of global economic data, Wang, 45, typically relies on a handful of technical charts and on her own gut instinct. "Keeping it as simple as I can is the best way -- otherwise, I won't ever make a trade," says Wang, who left her family's retail business in Old Bridge, N.J., in 2007 to day trade currencies full-time.
Still, day trading certainly is a strategy only for the brave, given that currencies can make hair-raising moves from day to day. According to a report by Aite Group, just 30 percent of all U.S. retail forex trading accounts are profitable in any given quarter -- and no one knows how deeply in the tank the big losers are. Many do-it-yourself traders, including Wang, focus only on short-term dynamics, which can lead to some awfully large hits in a portfolio -- especially when heavy leverage is used. (Retail currency traders can often borrow enough to turn a mere $1,000 in principal into a $50,000 bet; in the stock market, by comparison, the same trader would typically be able to leverage the same stake into just $2,000.) With such borrowing-to-bet tactics, naturally, a few big losses can quickly wipe out a small investor. Wang, for her part, admits she came close to that, losing $50,000 in her first year of full-time trading. But last year was a different story: She says she pulled in about $15,000 in profit, after fees.
In the end, the hope of making such tidy scores -- whether through day trading, or buying ETFs or mutual funds -- may be just enough to keep Main Street investors currency-curious for a while. In fact, despite the recent track record (and their own wound-licking), many financial advisers continue to see a case for allocating some of their clients' money to forex investing, if only as a hedge against the U.S. dollar -- the one bet that nearly every U.S. investor has gone "all in" on. Kim Arthur, of investment advisory firm Main Management, which shepherds $400 million in assets, often finds himself sounding the same message to clients: Their salaries are paid in dollars, their homes are valued in dollars, and virtually all of their investments and assets are denominated in dollars. Wouldn't they feel safer, he asks, knowing that something they owned wasn't? It is the question that legendary investor Jim Rogers has been asking for decades. He believes that fortunes can be made in forex -- but even if investors end up just above even in the currency market, he says, it is still worth investing in, if only as an "insurance policy." And in today's market, after all, having insurance may be as good as making money.