Cross-sectional strategies, in which investors buy or sell a basket of currencies based on their past performance, yield excess returns, or alpha, of up to 10% a year, says Professor Lucio Sarno of Cass Business School. Sarno, a former head of currency research at Axa Investment Managers, analysed the performance of 48 currencies against the dollar from 1976 to 2010, the most comprehensive analysis of momentum risk and returns in the currency markets to date, he believes.
“We find large currency momentum strategies yield surprisingly high unconditional excess returns of up to 10% per a year,” he says.
“These returns are particularly striking given they persist in currency markets characterized by sophisticated investors, huge trading volumes, an absence of short-selling constraints and considerable central bank interference.”
| Cumulative excess returns of momentum strategies |
| Source: Cass Business School |
The existence of such excess returns can be put down partly to slow information processing and investor overreaction, says Sarno. But he adds it is hard to believe that investor irrationalities of those kinds are not quickly arbitraged away in the FX market.
It is the difficulty of obtaining those returns, however, which means FX momentum strategies do not offer a free lunch to investors and creates excess returns.
The study shows profitable FX momentum portfolios are skewed towards non-G10 currencies, which have relatively high transaction costs. Those currencies account for roughly 50% of momentum returns.
However, the concentration of these non-G10 currencies in momentum portfolios raises the need to set up trading positions in currencies with higher volatility, higher country risk, and higher expected risk of exchange-rate instabilities, which imposes risks to investors.
“Hence, there seems to be effective limits to arbitrage which prevent a straightforward exploitation of momentum returns,” says Sarno.
“Furthermore, momentum profits are highly time-varying, which may also pose an obstacle to arbitrage activity for some of the key FX market participants, such as proprietary traders and hedge funds, which typically have fairly short-term investment horizons.”
Peter Eggleston, head of Morgan Stanley’s quant solutions group, welcomes the study given that it provides more evidence that alpha exists in FX, and that it can be treated as an asset class.
“With momentum, or trend following, there must be some alpha out there otherwise there wouldn’t be so many successful funds as there are,” he says.
“It is a style that generates returns and the fact that the academic paper is concluding that is very valid.”
Some still maintain that FX is just a medium of exchange and thus cannot be considered an asset class.
An increasing body of work, however, suggests that the presence of so many non-profit maximising market participants in the market – for example, companies buying raw materials – means that excess returns can be garnered in currencies. In other words, there is an awful lot of flow in FX for which the objective is not to make short-term or even medium-term revenue gains, but which institutions have to transact due to the natural course of business.
The problem with following a pure momentum strategy in FX, however, is that there are certain times when the macro regime that the market is in means it does not perform well.
As Sarno points out in his paper, relatively short-term time horizions mean most investors cannot cope with the losses when momentum falls out of favour. Indeed, momentum returns have fluctuated in recent years, performing badly in 2008, well in 2009, and then in 2010 performing poorly in G10 currencies but well for emerging market currencies. However, 2011 was a fairly good year for momentum.
Eggleston says that when looking at currency as an asset class, investors need to build a portfolio based on a variety of trading styles, including momentum, value, carry and volatility. That is because, at any one time, some of those styles will be underperforming and some outperforming.
The trick, of course, and where banks are focusing their research capabilities, is to know when to time the switch between different regimes.
“It’s almost the holy grail to some extent, because if we can build a portfolio of different currency styles, and have a decent way to switch between them depending on the macro environment we are in, then we can turn currency into an asset class that is consistently outperforming year in year out,” says Eggleston.