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.”

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.