Advisors and investors are keen to minimize the impact of geopolitical risks, distressed commodities markets and other factors on their portfolios – while improving returns, as well. This is driving many of them to take a deeper look at diversification and alternatives.
Can actively managed currencies help boost results?
That’s what Axel Merk and his colleague Daniel Lucas of Merk Investments analyzed recently in white paper released on Tuesday.
“Our findings suggest that actively managed currency strategies can significantly reduce volatility and minimize drawdowns in portfolios, and that viewing risk dynamics as a trading signal can generate consistent alpha over time,” they explained. The devil – of course – is in the details, which they explain through detailed analysis.
The argument for currencies “is quite compelling,” they point out, since currencies have shown low correlation with other major asset classes in the medium- to long-term.
Plus, the correlation of currencies also has been comparatively stable.
“The same cannot be said for other popular alternative assets, such as real estate, which shows a relatively stable but high correlation with equities, or commodities that have a low correlation but especially in times of higher financial turmoil appears to be unstable,” Merk and Lucas explained.
The low correlation to traditional asset classes, thus, make currencies “particularly qualified from a portfolio design perspective, and especially if we refer to a managed basket of currencies that follows a specific strategy with a non-zero expected return (such as well-known systematic strategies like carry, momentum or valuation), the inclusion of currencies as asset class is justifiable,” the add.
In their analysis, the portfolio specialists at Merk used Deutsche Bank’s Currency Return Index (DBCR), an equally weighted index of three common rule-based currency styles (carry, momentum and valuation) as a benchmark.
The foreign exchange market is “by far the most liquid market in the world, with more than $5.3 trillion in daily turnover worldwide,” the authors note, and this means it is considered highly efficient. But research show, the particular microstructure of the foreign-exchange market “actually suggests that currency markets are not efficient in the classical sense.”
Many large investors, like multinational corporations, central banks and government institutions, use foreign exchange for cash management purposes or currency hedging, rather than for making profits.
This provides a source of alpha for the active participant, Merk and Lucas explain. They add that profit-seeking active investors can thus potentially exploit the market’s short to medium-term market inefficiencies.
The Merk team looks at how to best generate excess returns from currencies by targeting dynamics in risk sentiment, which are tied to perceptions of changing market conditions, in the FX market.
They notice that over a 10-year span, both passive currency and active currency approaches, as well as managed futures, seem to be largely uncorrelated with a 50/50 base portfolio. (In addition, real estate, hedge funds, private equity and to some degree commodities show higher average correlations, the study finds).
With back testing and other analysis, the researchers conclude that only active currency and real estate as partial allocation “were able to enhance returns of the portfolio.”