Few currency managers will remember 2012 with much affection. Low interest rates in leading economies, combined with sharp reversals and periods of volatility, have played havoc with the carry and momentum strategies, resulting in low returns for many.
Still, amid the gloom there were pinpricks of light, and those managers that moved away from conventional strategies were rewarded.
Carry and momentum trades have historically been the twin pillars of the FX markets, providing steady returns over a near 20-year period.
Carry comprises selling or borrowing in low-interest-rate currencies and buying currencies of countries with higher rates. Momentum consists of going long or short currencies, for which long positions have yielded positive (negative) returns in the recent past.
A 2008 study by Richard Levich, an NYU professor of finance, and Momtchil Pojarliev, an FX manager, found that carry, momentum/trend, value and volatility explained nearly 76% of average annual excess returns generated by currency managers from 2001 to the end of 2006, with carry and momentum being the most significant drivers.
Since the financial crisis, however, uniform low interest rates across leading economies have resulted in a carry headache for FX investors, while central bank interventions in Europe and the US have played havoc with momentum dynamics.
The implications of quantitative easing have been difficult to read and inconsistent, at different times being US dollar negative, euro positive, sterling neutral and mildly positive for the yen.
Index providers show how difficult it has been for currency managers to generate returns. The Parker FX Index, which tracks the reported and risk-adjusted returns of 49 global currency managers, showed reported returns of -1.28% in the year to the end of October net of fees, and risk-adjusted returns of -0.55%. The BarclayHedge BTOP FX Index, which replicates returns in the managed futures industry, indicates a return of 1.55% year-to-date.
In response to the challenging environment, many FX managers have tweaked strategies or looked for new models to find pockets of value and opportunity. Among those trading G10 currencies, some have generated better-than-average returns by focusing their efforts on non-core countries.
"We have produced excess returns of 3.4% to 3.5% in G10 carry by going beyond the G5, including to the Australian, Canadian and Kiwi dollars," said James Wood-Collins, chief executive officer at Record Currency Management. "However, it has been a choppy year."
Record’s emerging market strategy was relatively successful in 2012, returning 6.5% from going long higher-yielding currencies and short developed markets.
Another firm to benefit from non-core markets was London-based macro strategy fund Harmonic Capital, which played relative value on pairs, including the New Zealand and Australian dollar and the Brazilian real against the Mexican and Chilean pesos.
"Fundamentals have helped us have one of our best years," said investment partner Patrick Safvenblad. "Risk-on risk-off is still around but in a relative sense we have seen emerging market currencies respond to local conditions."
Uncertain backdrop
One of the biggest challenges for currency managers has been sudden reversals in markets, partly the result of political interventions in Europe, and high short-term volatility, which led to losses in trend-following strategies. Record Currency Management’s trend-following strategy was down 5% to 6% in 2012.
Other investment mangers, meanwhile, have exploited higher short-term volatility by focusing on intra-day trading, based on short-term correlation with other asset classes, momentum and mean reversion.
Some firms have looked to diversify and Brussels-based Global Capital Management introduced new models borrowed from other asset classes.
"We are looking to diversify the asset mix, for example, to crude oil, gold, equities and treasuries," said managing partner Jan Hillen. "By broadening our scope, we hope to appeal to a wider pool of investors."
Few currency managers are confident about how the environment will develop in the coming year. However, some say the monetary landscape is unlikely to change any time soon.
"In terms of rates, it’s likely to be more of the same but we may see less tension in Europe," said Hillen. "And if the US gets past its fiscal cliff, fundamentals could come more into play."