Benefits of momentum
Moreover, when building an overall portfolio, institutions need to be aware that momentum is not the sole preserve of the currency world. “There is quite a lot of academic research out there that shows it works well for other asset classes whether it is equities or fixed income. One of the main benefits is that the strategy is a good diversifier,” says Hahner.
The real question investors should be asking according to Towers Watson senior investment consultant Matthew Roberts is “whether the hedge fund fees tied to these momentum strategies are worth paying when they can get access to the same revenue streams through different, less expensive products”.
Last but certainly not least, investors should not view the results in the Cass or any other scholarly report as a template for the future. Academic studies are always useful to compare the promises being made today with the results which were delivered in the past, says Mercer Investment Consulting principal Malcolm Leigh. “Today, everything is focused on global growth but I expect that there will be a resolution of the economic situation and that the risk on/risk off trade will gradually diminish in importance. Other factors that are more idiosyncratic to each country will play a more important role and the ability of momentum to add value for developed market currencies will become as significant as it is for emerging markets.”
This is why Leigh as well as others believe institutions need to adopt a wider view. “If you have a style that is volatile, then there will always be periods where it delivers double digit returns and another period where it could be down by a double digit figure,” he says. “For me the question is the certainty and reliability of those returns. Our advice in currencies is the same as in other asset classes – investors need to look at different styles of returns.”
Hahner also points to research from James Binny (currently portfolio strategist at Brevan Howard) which found that there was no individual inefficiency or style of manager that made money in every sub-period, but that individual manager styles were, on average, uncorrelated. Importantly, there was no medium-term period when all styles were positively correlated which is why diversification between managers works.
Different characteristics
While there are different variations on the currency theme, the general consensus is that there are four distinct strategies with momentum or trend and the carry trade or forward bias being the most popular.
The two are also highly correlated because they are both trend following. Carry though, which involves borrowing in low-interest rate currencies to buy ones that have higher rates, was the favourite until the financial crisis.
The Cass study shows that those involving major currencies such as the yen, US or Australian dollar were the most profitable in the 1980s and 1990s and were barely impaired by two economic recessions in the early 1990s and 2000s.
Overall, research by Elroy Dimson, Paul Marsh and Mike Staunton of the London Business School revealed that the annual return since 1971 (when Bretton Woods collapsed) has been 2.3%. However, their undoing came between August 2008 and January 2009 when, for example, the relatively high-yielding pound dropped by more than 44% against the yen.
Monetary policymakers across the board cut interest rates to combat stagnant growth and as a result, there were less inefficiencies to exploit. The trade has not recovered its former glory with the TDB Global Currency Harvest Index, which tracks the performance of a portfolio of carry strategies, off 0.5% last year.
Value, which consists of buying undervalued currencies and waiting for them to rise, has also struggled with the DB Value Index down 2% in 2011. However, it only accounts for a small portion of currency investing because of the longer time horizon required while short volatility, which relies on selling options to protect against volatility, comprises just a fraction due to the reliance on purely speculative currency trading.
Value and momentum are good diversifiers whereas carry performs well except when risk appetite turns negative. “This can lead to sharp drawdown events which without risk management can be costly,” says Wood- Collins. “We have a suite of long-term return seeking strategies in currency management and what we try to do is build the best class in each.”
Kittler also believes that investors should take another look at the carry trade but from a different perspective. The bank for example does not always follow the traditional interest rate dynamics and will instead conduct a trade between two high interest rate currencies such as the Turkish lira and South African rand. They are highly correlated against each other but not against the US dollar.
“Carry is just the name of the trade but that doesn’t mean it has to be a low and high interest rate trade,” says Kittler. “Our goal is to minimise volatility within the given target rate set by investors for the portfolio.”
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