Go with the flow: is the return worth the risk in currency momentum?

3 Jul 2012

Currency momentum’s stellar performance in a recent study may have looked impressive, but investors are advised to investigate beyond the numbers. The strategy not only requires patience but an appetite for risk as the results are tied to emerging market currencies which can be unpredictable. This is why, as with other asset classes, fund managers do not advocate relying on one strategy but a well-diversified portfolio.

“It was easier when trends were longer and more pronounced. Now you have to identify shifting and volatile regimes and time horizons are much shorter.”

James Wood-Collins

In general, momentum strategies are based on buying and selling currencies moving in one direction. The study by Cass Business School, which analysed 48 currencies against the US dollar from 1976 to 2010, showed that momentum produced excess returns of up to 10% a year. Cross-directional strategies – where investors buy or sell a basket of currencies based on their past performance – fared the best even after factoring in high transaction costs.

The results are “particularly striking given they persist in currency markets characterised by sophisticated investors, huge trading volumes, and absence of short-selling constraints and considerable central bank interference,” notes Cass professor Lucio Sarno, co-author of the report, Currency Momentum Strategies, along with Lukas Menkhoff and Maik Schmeling, both with Leibniz University Hannover and Andreas Schrimpf from the Bank for International Settlements.

The star performers were emerging market countries which have greater economic, political and financial risks as well as less stable exchange rates. They outshone their developed counterparts, especially the AAA-rated sovereigns. The most successful currencies were those at the smaller end of the scale such as the Brazilian real, South African rand and Philippines peso even though higher transactional costs in these liquid markets erased around 30% to 50% of the profits.

The main reason is not only that market turbulence allows for trends to develop, but also, as Sarno points out, erratic moves in volatile currencies make it harder for potential speculators to hedge against momentum strategies and prevent arbitrage from wiping out returns. “This hampers the exploitation of momentum profits and is an important factor in explaining the persistence of momentum returns in FX,” he says.

No free lunches

However, although the profits may seem alluring, investors are warned that like other strategies, there are no free lunches. This is particularly true in small and volatile currencies where timing the moves can be tricky. A long-term horizon is a pre-requisite in order to reap the benefits and ride out the excessive swings. The strategy can disappoint in the short term as this year has demonstrated; uncertainty over global growth and the fate of the eurozone crisis has taken its toll.

In fact, the Nomura’s Storm FX Trend index, which tracks momentum-based currency strategies, lost about 0.9% by the end of April. Volatility has diminished as central banks in emerging markets such as Brazil have intervened. This has meant that many currencies are trading in tight ranges against each other and as analysts note during these ranging periods, trend-based strategies can buy high towards the top of a range and then sell low at the bottom which they misidentify as breakouts.

According to Record Currency Management chief executive James Wood-Collins, momentum has always been a difficult strategy to design but the current environment has exacerbated the situation. The time period for benefitting has become shorter due to the so-called risk-on/risk-off phenomenon that has dominated markets since the collapse of Lehman Brothers in 2008.

“It was easier when trends were longer and more pronounced. Now you have to identify shifting and volatile regimes and the time horizons are much shorter. This means that you risk constantly changing direction in which case your trading costs can consume the benefits of following trends,” he says.

In addition, greater country risks and exchange rate instability can help generate strong returns but they can also work against the strategy. Governments could, for example, suddenly introduce capital controls preventing repatriation of capital by foreign investors or intervene in the markets. Traders using these strategies lost money last September when the Swiss National Bank took the unanticipated move of setting a cap on the value of the franc.

Although the Cass research highlights the pitfalls of momentum, market participants also believe that investors should put the report itself into perspective. This is especially true with the data used to crunch the numbers.

“My impression is that the authors of the Cass study did a good job taking into account the right information, but data in the 1970s and 1980s is not reliable because markets were less liquid and it is difficult to get all the information,” says DB Advisors portfolio manager Daniel Kittler. “The data they used was mainly at the end of the month versus the daily mark to market data of today.”

Allianz Global Investors money manager Andreas Hahner agrees. “It is a struggle to get tradable and accurate data from 20-to- 30 years ago,” he says. “It would have been better to use data starting in 1995 which is more reliable until the beginning of the financial crisis, where there was extreme carry in emerging markets. The other issue is that using 48 currencies is more of an academic approach. In the practical world, clients have too many restrictions and guidelines to follow and typically only trade around 20.”

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