Lynn Strongin Dodds finds that worries about currency risk are leading investors to consider factor-based approach when investing in foreign exchange markets
At a glance
• Currency volatility has become more pronounced with the diverging interest rate environment.
• Factors in this area include value, momentum and carry.
• Currency factor-based investing is slowly catching on as investors become increasingly worried about foreign exchange risk.
Although carry is a well-worn factor in foreign exchange (FX) markets, the development of smart beta or factor-based investing has not really taken off, although the tide is slowly turning. There are several challenges but recently the approach has been introduced into overlay strategies, exchange-traded products, as well as multi-factor-based funds as investors have become increasingly concerned over currency risk.
“A lot has changed within the past two years and investors are no longer looking at smart beta as a marketing gimmick,” says James Wood-Collins, CEO of Record Currency Management. “They are realising that factors similar to those in equities exist and can be harvested in other asset classes including currencies.”
In the past, the lack of a straightforward benchmark has been one of the main stumbling blocks. Unlike their fixed-income and equity counterparts, there is no index to make comparisons or judge a manager’s performance. Moreover, the trading universe is limited to mainly the G10 currencies (of the leading developed nations) which does not offer the same depth and breadth of equities where there are thousands of stocks.
However, volatility in currencies is much more present today with the diverging interest rate environment. The US has embarked on a higher path – the Federal Reserve hiked rates by a quarter point in March and more is expected throughout the year. This is in contrast to the UK and Europe which for now, are staying the course and not moving the needle.
Political risk has also reared its head in the shape of Brexit and many managers were on the wrong side of sterling when the UK voted to leave the European Union. For example, at the time of writing the pound had plummeted by 17% against the dollar since June but there is also nervousness about the possible victory of far right candidate Marine La Pen in the impending French presidential elections.
As Van Luu, head of currency and fixed income strategy at Russell Investments, puts it, unmanaged, currency fluctuations are a source of unrewarded risk but a deliberate exposure to well-understood currency strategies can be a valuable source of returns. “It is more than a zero-sum game and these so-called currency-factor strategies can help to enhance returns with modest or no additional risks, given the low correlation of currency strategies to traditional asset class strategies,” he adds.
Luu argues that rules-based strategies can be implemented with liquid currency forwards and that the same factors present in equities such as value, momentum and quality are present in FX. “We believe that these factors give investors compensated sources of risk and we are seeing them being used as part of an overlay, as well as in absolute return strategies”.
Luu also notes that these strategies would have mitigated the event risk around Brexit because they would have spotted the return and risks associated with currencies around the referendum. “For example, by being long the yen and short the pound going into the vote, an investor who used a strategy like this would likely have benefitted from very strong returns,” he says, adding that Russell Investments’ Conscious Currency index returned 3.5% plus in June alone and 3.8% plus for all of 2016.
To date, carry which buys currencies with high interest rates and sells those with low interest rates, is the most popular and one with the longest track record. One reason for its success, according to research from Unigestion, is that it represents compensation for exposure to the economic (consumption) growth risk, or to the risk of economic disaster. This is because the trade typically involves going short reputedly ‘low-risk’ economies and currencies which investors would be expected to pay a premium to hold.
This is also evidenced in an academic study by Cass Business School that analysed 48 currencies against the dollar between 1983 and 2009. It found that carry trade profits, which amounted to an average of more than 5% a year even after accounting for transaction costs, can be explained as a reward for the significant risk investors undertake.
Different factors often have different characteristics in currencies. Value, which moves into undervalued currencies and out of overvalued ones, has proved a good diversifier. So has momentum, which tilts exposure towards currencies that have recently gone up, and away from currencies that have gone down. Carry performs well except when risk appetite turns negative. Although all three will hit bumps in the road in the short term, research from Russell, which adopts a different time frame from Cass, shows that they have performed well over time. From November 1999 to March 2015, the annualised returns were 3.81%, 1.62% and 5.15% respectively for value, trend and carry.
Constructing a FX factor-based strategy does not have to be complicated, according to Phil Tindall, head of smart beta at consultancy Willis Towers Watson. “Indices are useful to measure a manager’s performance but you do not need a formal index to build a smart-beta strategy” The FX market is extremely liquid and therefore smart-beta strategies are very scalable,” he says. “Also, the FX universe is not as concentrated as you think. There may be only 10 currencies that people focus on but, within that, you can have 45 currency pairs. With an additional, say, 10 to 20 emerging market currencies, the number of pairs multiplies up considerably.
The objective, according to Tindall is to apply a long-short hedge fund-type framework which has little market exposure, and is therefore rich in diversification from traditional markets. It also employs different measures to determine the weightings. For example, in value, purchasing power parity is one measure used to assess what is expensive and what is cheap and then make the adjustments accordingly. This is different from value measures used in other markets, and so adds diversity.
Wood-Collins also says FX’s unique characteristics – a highly liquid market with many non-profit-seeking participants such as corporates and central banks, as well as the ability to invest on an unfunded basis – present opportunities that are not evident in other asset classes. “They are not always easy to identify but when you do, you they show persistence,” he adds.
The average total daily turnover of FX instruments averaged $5.1trn (€4.8trn) a day, according to the latest Bank for International Settlements survey in April 2016. By contrast daily turnover for the last five days on the London Stock Exchange ranged from £4.3bn to £4.5bn (€5.0bn to €5.3bn).
Wood-Collins’ colleague Jan Witte, head of Quantitative Research, says that factor-based FX strategies will continue to gain momentum. “In part, due to regulation, fund managers are being held to account more and more and underlying sources of return are now studied carefully,” he adds. “There is willingness amongst larger and more sophisticated investors to look at factors purely in currency but we are also seeing growing interest in cross-asset products, although this will take time and greater education. This is because when you look at strategies in FX and compare them to their counterparts in other asset classes there is a certain commonality which performs well based on academic research.”
FX factor-based investing is slowly catching on as investors are increasingly worried about currency risk. Diverging interest rates between the US and UK and Europe as well as political risk most notably Brexit and European elections are making investors nervous
FX is a highly liquid market with many non-profit-seeking participants and offers the ability to invest on an unfunded basis which presents opportunities that are not evident in other asset classes. As fund managers are held more accountable for performance, they are looking at currency to generate added returns.
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