Currency investing: Skill versus smart beta

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The real possibility of Brexit has turned investors’ attention to the recent weakness of sterling and currency developments in general. Unsurprisingly, I have fielded more questions than usual on foreign exchange markets over recent weeks.

Very often, currency is a mere afterthought in the deliberations of investors. I think this is an opportunity missed. Left unmanaged, currency fluctuations are a source of uncompensated risk. On the other hand, deliberate exposure to well-understood currency strategies can be a valuable source of returns.

The traditional way of gaining access to returns from currency markets is to hire an active currency manager. More recently, investors have also been able to select from smart beta currency strategies based on currency factors. But how to choose? Picking a good active currency manager can be every bit as demanding as choosing an active equity or bond manager. Needless to say, choosing a winning smart beta strategy is not a trivial task either. So my colleagues and I at Russell Investments wanted to bring some research to bear on the subject. Our aim was to analyse the returns from the main currency factors and to see how far these explained active currency managers’ ability to make money in currency markets.

Our study set about explaining a sample of currency manager returns using three well-known currency factors – namely carry, value and trend. We combined these three factors on an equally weighted basis, as measured by the Russell Conscious Currency Index (RCCI). RCCI would have yielded a 3.5% annual return at 4.5% volatility over the period between December 1999 and December 2015. Our hypothesis was that good traditional active currency managers should be able to add value (alpha) by generating excess return above and beyond the beta exposure to the three equally-weighted currency factors as represented by RCCI.

While some active managers did add significant value over the RCCI passive factor index, this is not necessarily true for the majority of them. Our analysis suggests that the currency factors included in RCCI could explain a substantial part (and as much as half) of the individual active manager returns in the period between 2004 and 2014. Only about 1 in 6 managers in our sample produced an alpha that was statistically significant and positive, above and beyond exposure to our selected RCCI factor strategies.

So, what can we conclude from our research insights? Skilled active currency managers exist, but thorough due diligence is required to identify them. My colleagues in Russell’s manager research team do so by conducting in-depth interviews to assess an active manager’s processes and staff. The alternative to hiring a traditional active currency manager is to gain exposure through a smart beta approach using factor strategies such as carry, value and trend. The big advantage of a well-constructed rules-based investment process in currency management is that it can produce consistent pay-offs and is not dependent on the skill of individual portfolio managers. It is also flexible – for example, you can use the RCCI factors either with equal weights or with customised weights to take into account other factor exposures in your portfolio. On the flipside, combining a number of strategies means that you will not achieve the top returns that come with picking the single best strategy or an outstanding active manager

With a thoughtfully-constructed smart beta currency strategy, you may never hit the ball out of the ground, but you have a good chance of reliably scoring consistent runs that build up to a worthwhile innings. This type of strategy can also provide valuable diversification benefits and additional return drivers for a global bond or multi-asset portfolio.

 

Van Luu, Head of Currency and Fixed Income Strategy

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