How Can Investors Make Returns on Actively Managed FX?

Currency markets are volatile and speculative traders make the wavers higher, but long-term investors can still make a profit, an academic paper says.

(April 30, 2012) — Investors with a long time horizon can make up to a 10% annual return on a currency allocation, according to Cass Business School – but should be aware of the trip wires, it has warned.

Professor Lucio Sarno of Cass Business School found large currency momentum strategies yielded “surprisingly high unconditional excess returns of up to 10% a year”, in a report entitled ‘Currency Momentum Strategies’ to be published in the Journal of Financial Economics.

‘Cross-sectional strategies’ – where investors go long or short on a basket of currencies based on their past performance – yield the highest returns, even when accounting for transaction costs, the report found.

Sarno said: “These returns are particularly striking given they persist in currency markets characterised by sophisticated investors, huge trading volumes, an absence of short-selling constraints and considerable central bank interference.”

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However, the authors of the paper said investors needed to be aware that while the returns were attractive, there were risk factors to be taken into account.

The most successful momentum portfolios in foreign exchange markets were significantly skewed towards minor currencies that have relatively high transactions costs – these currencies accounted for between 30% – 50% of momentum returns, the report showed.

Profitable portfolios also required buying and selling currencies with high volatility at the right time, such as those of emerging markets countries like Brazil, South Africa or the Philippines.

Market speculators betting on the short-term movements of currencies could help those investing over a longer time horizon to profit, the paper reported.

“Highly idiosyncratic movements of a currency make it harder for potential speculators to hedge their positions,” Sarno said. “This hampers the exploitation of momentum profits and is an important factor in explaining the persistence of momentum returns in FX markets.”

Investors should hold on to these strategies for the long term, the paper found, as returns were not constant – it stressed that most currency speculators measured their performance over a relatively short time frame.

Last year was disappointing for active equity managers and as an overall climate of risk aversion persists, many of the early indicators of a risk recovery are emerging, Wellington concludes.

(April 30, 2012) — Opportunities for active equity managers to make outstanding returns for their clients were scarce in 2011, according to a recent whitepaper by Wellington Management.

Macro-driven risks associated with political and fiscal uncertainty, which caused unprecedented high correlations, were the greatest culprits, Wellington said. The firm also said that because of the scarce opportunities for active managers, they should focus on securities in which they have a truly different opinion. “Trying to time 10% movements in stocks, industries, or countries won’t move the needle much overall,” Wellington said.

Consequently, according to the firm, the focus on safety among investors was nearly as extreme in 2011 as it was in 2008, when the market was down almost 40%. “We found that while 2011 and 2008 ended with very different market returns, they shared many traits, including massive risk aversion and an extremely narrow opportunity set of market-beating stocks, which severely limited the ability of active managers to add value,” Wellington asserted. “The good news is that historically these flight-to-safety periods have tended to be fairly short-lived, and if that trend holds, we would appear to be on the cusp of an excellent period for risk assets.”

While few of the typical warning signs of a return to safety within portfolios were triggered in 2011, many of the early indicators of a risk recovery are emerging, Wellington concluded, outlining the following factors:

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1) High-yield spreads are contracting.

2) Volatility is moderating, and the volatility curve is no longer inverted (short-term volatility is now lower than long-term volatility).

3) Housing and housing stocks are turning in some surprisingly good results.

4) China has been one of the better-performing non-US markets recently, and several of the country’s leading indicators have turned positive.

Wellington’s conclusions regarding active equity managers contrasts with another report by the firm released earlier this year, which asserted that equities will have long-term return benefits for most investors despite the asset class underperforming bonds over the past 15 years.

Ultimately, the authors of the report on equities over the long-term concluded that they believed investors should base strategic asset allocation decisions on fundamentals and valuations, rather than on recent returns. While allocations to other areas of fixed-income or to alternative asset classes may be appropriate, there are often limits to their use, such as liquidity constraints and the skill required to select and monitor complex strategies. Thus, the paper asserted: “We believe that current market conditions and historical capital market behavior suggest that now is a good time for investors to examine their fixed income and equity allocations to determine if they have the appropriate exposure to equities to meet their long-term objectives.”