It is well known that currency markets are hard to predict and not a market for the average investor. Professionals, on the other hand, devote serious energy and resources to the task of predicting exchange rates. Professional managers at hedge funds and commodity trading accounts oversee millions, and indeed billions, of dollars earmarked for currency investment. And managers often charge a hefty fee for their professional advice; 2% per annum based on the capital under management and 20% of any profits are typical for the hedge fund industry. To a greater extent than ever, institutional investors are spreading their investments out beyond the traditional pots of equity and bonds, into real estate, private equity, and alternative investments including currency. Previous studies, such as Froot and Thaler (1990) and Neely, Weller and Ulrich (2007) have shown that simple currency trading strategies are at times quite profitable. Two questions naturally arise: How have professional currency managers been faring, and are their returns high enough to justify large fees?
In recent research, we take a first look at the performance of a broad index of professional currency managers and the performance of a group of 34 individual managers (Pojarliev and Levich, 2007). To gauge performance, clearly we need a benchmark. But the notion of what benchmark to use when it comes to currency management is not clear.
What is the benchmark for currency trading?
For a currency overlay manger (someone with a mandate for trading on the basis of assets invested elsewhere), the conventional standard has been zero. If the overlay manager does nothing, he earns zero return. For an absolute return program manager (who holds assets under management), the conventional standard has been the risk-free rate, the rate associated with leaving the assets unmanaged and in cash.
These benchmarks have held credibility for several reasons. First, rigorous academic studies have concluded that currencies are difficult if not impossible to forecast. Many market professionals share that view. If trades are as likely to make a gain as to make a loss, then the expected value of a currency manager’s trading is zero – so any profit becomes an unusual profit. Second, financial theory has been agnostic as to whether currency risk is the type of systematic risk (like equity market risk) that ought to earn a risk premium. In some theories, investors can avoid currency risk entirely by taking carefully hedged positions. Currency has been labeled a “zero beta” asset, because empirically currency returns have been uncorrelated with returns in other asset classes like equity, bonds or real estate (see Burnside, et al. 2006). And according to traditional capital market theory, if there is zero beta risk, there is zero expected return.
However, there is another way to go about constructing a benchmark. If investors can easily implement one or more trading strategies that are transparent, then the return on those strategies could serve as an alternative benchmark. In the last year, both Deutsche Bank and Citibank have introduced several indices that track returns from several well-defined trading strategies.
- Carry – To reflect the returns on the well-known strategy of borrowing a low interest rate currency and investing in a higher interest rate currency
- Trend following – To reflect the returns of strategies related to identifiable patterns in currency movements
- Value – To reflect the returns on taking short positions in overvalued currencies and using the proceeds for long positions in undervalued currencies
Each of these trading strategies is “transparent” because the rules for executing the underlying trades are explicit. And each of the strategies is easily implemented, in part because they are so well known and straightforward, but also because execution costs in currency markets are so small.
In our approach, because these three “trading styles” have been shown to produce positive returns and because they are so easily implemented, they constitute a reasonable benchmark. In addition, we include currency volatility as an additional factor that could influence currency trading returns from month to month. Professional managers who bring special skills and market knowledge into the equation ought to do at least as well as our alternative benchmark.
How do currency managers measure up?
In our study, we analyse an index of professional currency managers over a 17-year period, 1990-2006. Overall, these managers (as many as 113 at the end of our sample) achieved 25 basis points (bps) per month in excess returns, over and above the risk-free rate. Earning 400 bps per year, in addition to the risk-free rate, on average over 17 years sounds like an impressive record. But looking more closely, we find that these returns are very closely linked to our basic factors representing “trading styles.” These factors explain more than 66% of the variation in returns over time. “Trend” is by far the most important factor for explaining returns, but “Carry” and “Value” and at times “Volatility” also play small roles. Once we compare the index of returns to the alternative benchmark, superiority in performance (the so-called “alpha”) is not different from zero. Professional currency managers are doing well, but as a group, they could have done just as well by executing some simple, straightforward trading strategies, none of which would easily justify a high management or performance fee.
The results for the group might not be so for each and every manager. So we also examine the performance of 34 individual currency managers who were part of the index over a shorter period (2001-06) when all were active. Once again, the basic factors play a substantial role in accounting for the realised returns for many funds. Twenty-seven of our 34 funds generated returns greater than the risk-free rate, but only 8 of the 34 funds produced excess returns relative to our alternative benchmark, and could be labeled as true “alpha generators.” In other words, many funds generated returns, but for the most part, these returns were related to simple trading strategies, or returns for taking beta-style risks. In fact, our results showed a significant trade-off between the two sources of returns. The more funds earned beta returns related to the basic trading factors, the less likely they were to earn alpha returns for superior performance unrelated to the basic factors.
Not all is bad news for currency managers. Approximately one quarter of the managers was able to generate positive and significant alpha between 2001 and 2006. The average alpha of these “stars” has been quite high at 104 bps per month or 12.48% per year and significant. Importantly, this 104 bps alpha is measured after taking into account the four explanatory factors – carry, trend, value and volatility. In addition, there was substantial consistency between results in the first half of our 6-year period and the second half. We identify 8 managers with positive and significant alpha in the first half of the sample, and 7 of those continue to make positive alpha in the second half. While alpha was smaller in the second half and harder to earn, no manager shows significant alpha in the second half who did not also produce alpha in the first half. So in some respects, currencies seem not so different from other asset classes: The average manager might underperform, but there exist some skilled managers who are able to deliver significant alpha.
There is a reasonable case to support the notion that professional currency managers ought to be held to a higher standard of performance than simply zero added return over and above the risk-free return on assets they hold. While theoreticians may argue over whether currency risk, like equity risk, always deserves a risk-premium, as a practical matter, institutional investors willing to hold currency risk can do so using a variety of simple trading strategies. Many of these strategies have been profitable recently and exchange-traded funds built on those strategies have been launched for the retail market. It is questionable whether professional currency managers can continue to charge higher management and performance fees while delivering cheaper-to-obtain beta returns. However, our results show that even when evaluated against the higher standard, some currency managers show superior performance, and true alpha. How they achieve this may in part be due to superior market-timing ability, trading in emerging market currencies, or some other factors. Whatever their formula, their returns appear unrelated to some conventional simple trading strategies. These true “alpha generators” may deserve their fees after all.
Burnside, C., M. Eichenbaum, I. Kleschelski, and S. Rebelo, “The Returns to Currency Speculation,” NBER working paper 12916, August 2006.
Froot, K. and R. Thaler, “Anomalies: Foreign Exchange,” Journal of Economic Perspectives, Summer 1990, pp. 179-92.
Neely, C.J., P.A. Weller and J.M. Ulrich, "The Adaptive Markets Hypothesis: Evidence from the Foreign Exchange Market," Federal Reserve Bank of St. Louis, Working Paper 2006-046B, March 2007.
Pojarliev, M. and R.M. Levich. “Do Professional Currency Managers Beat the Benchmark?” NBER Working Paper 13714, December 2007.