Poster Valkenwaards Schoolzwemkampioenschap 2015

VIEWPOINT
Currency strategies
and bond portfolios
Yoel Prasetyo, CFA, CAIA, Senior Research Analyst
Kevin Lo, Portfolio Manager
The role of currency in investment portfolios has not yet been clearly defined.
Views range from considering currency as a byproduct of international
investments to seeing it as its own asset class. The objective of this paper is
to promote greater understanding of currencies and to better define currency
trading as an investment strategy.
Our view is that currency strategies can play an important role in both multiasset and single-asset portfolios. For investors in multiple assets, a potential
diversification benefit derives from currency’s low correlations with multi-asset
portfolios, and for investors in single assets – particularly, fixed income
portfolios – currency may serve as both a diversifier and a potential source of
returns. In this paper, we will discuss currency’s role in fixed income portfolios,
in addition to where currency and bond strategies historically have shown
similarities in terms of market characteristics and underlying investment
theses.
The Evolution of the Barclays U.S. Aggregate Bond Index
Historically, U.S. institutional investors’ fixed income exposures have been predominantly in
the Barclays U.S. Aggregate Bond Index (“Agg”). However, highly accommodative monetary
policy by the U.S. Federal Reserve (“the Fed”) after the recent financial crisis has altered both
the fixed income market and the characteristics of the Agg. Consequently, Agg-like exposure
has grown increasingly more sensitive to the detrimental effects of rising interest rates.
Since its inception in 1986, the Agg has often been used as a proxy for the broad U.S. bond
market. It is one of the most popular benchmarks for multi-sector intermediate fixed income.
Between January 1986 and December 2013, the Agg produced an annualized return of 7%
with 4% annualized standard deviation. The Agg has had only three negative years (1994,
1999, and 2013) since its inception. Investors have benefited from this great performance in
large part due to a long-term trend of decreasing Treasury yields.
Russell Investments // Currency strategies and bond portfolios
FEBRUARY 2014
Exhibit 1: Historical 10-Year Treasury Yield
10-year treasury yield (%)
15
12
9
6
3
0
Source: As of Dec 31, 2013: Bloomberg.
Following the recent financial crisis, interest rates are at historic lows, and the Agg’s ability to
cope with rising rates has faltered due to two changes in the index characteristics. First, the
U.S. Treasury’s substantial debt issuance following the financial crisis has resulted in an
increase in the Treasury sector weight in the Agg, from low-20% levels during the pre-crisis
years to the current level of 36%. Consequently, the weight of spread sectors, which could
potentially act as a cushion in a rising rate environment, has decreased. Second, due to more
longer-maturity bond issuance, the duration of the Agg has been increasing, which means it is
more sensitive to interest rate changes.
Exhibit 2: Barclays U.S. Aggregate Bond Index Sector Weights, Yield and Duration
Index weight
100%
80%
60%
40%
20%
0%
Treasury
Government-Related
Corporate
Securitized
Dec-03
Dec-04
Dec-05
Dec-06
Dec-07
Dec-08
Dec-09
Dec-10
Dec-11
Dec-12
Dec-13
Yield (%)
4.2
4.4
5.1
5.4
5.3
4.0
3.7
3.0
2.2
1.7
2.5
Duration (years)
4.5
4.3
4.6
4.5
4.5
3.7
4.6
5.0
5.0
5.1
5.6
Source: Barclays This index and subsequent indexes shown are unmanaged and cannot be invested in
directly. Past performance is not indicative of future results.
The evolution of the Agg has prompted many investors to reevaluate the structure of their
fixed income investments, and currency is an area in which they may see promise.
Historically, currency strategies have had low correlations to interest rates, which may indicate
their potential to help investors diversify away from the interest rate exposure in their existing
fixed income holdings. Furthermore, in a multi-asset context, a diversified set of currency
strategies can provide for interest rate diversification in a fixed income portfolio without
materially adding more to the credit and equity risk in an investor’s overall multi-asset
portfolio, unlike other possible alternatives (e.g., preferred securities, bank loans, corporate
floating rate notes).
Russell Investments // Currency strategies and bond portfolios
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The Currency Market
All investors already have exposure to the currency market, because every investment is
denominated in a currency. For U.S.-based investors, the largest currency exposure will
typically be long the U.S. dollar. However, because U.S. investors usually measure their
performance from a U.S. dollar base, the long U.S. dollar exposure does not contribute to a
portfolio’s absolute volatility. The currency market is driven primarily by relative inter-country
differences in interest rate, inflation level, capital market flows, monetary policy, international
trade and political risk. Most of these factors are observable and quantifiable. Therefore,
currency managers tend to analyze these factors using a systematic approach and
quantitative models in order to understand currency behavior. Generally, currencies exhibit
similar characteristics when their factors are similar. For example, countries experiencing high
inflation will have depreciating currencies, as the markets perceive that inflation is eroding the
value of the currencies. In countries experiencing significant capital inflow, currencies will be
appreciating.
The value of one currency is always relative to that of another; thus, currencies are traded in
pairs (buying Currency A and selling Currency B). In its 2013 Triennial Survey, The Bank for
International Settlements reported that the average daily currency turnover had surged from
$4 trillion in 2012 to $5.3 trillion in 2013. The high level of annual turnover makes the currency
market one of the most liquid markets in the world. The average daily currency trading is
dominated by several currencies, with the U.S. dollar, euro, Japanese yen, British pound
sterling and Australian dollar making up more than 80% of the daily trading volume. The
report also shows a significant increase in the global importance of several major emerging
market currencies, particularly the Mexican peso and Chinese renminbi, which are now
among the world’s 10 most actively traded currencies.
In recent years, currency trading surged as global central banks flooded markets with zerointerest-rate policies to stimulate economic growth and combat the global financial crisis.
Some central banks intervened by weakening their currency to help exporters, while others
imposed a cap to stem their overvalued currency.
Exhibit 3: Currency Market Characteristics
World Currency Trade
M&A and FDI
3%
Currency
Managers
7%
Portfolio Flows
9%
Currency Trading Volume
Central Banks
1%
Tourism
1%
Corporate
Treasury
57%
Trade Flows
22%
Average Daily Volume ($ trillion)
Top five currency share of daily turnover (%)
USD
EUR
JPY
GBP
AUD
TOTAL
Top five currency pair (%)
USD/EUR
USD/JPY
USD/GBP
USD/AUD
USD/CAD
TOTAL
2004 2007 2010 2013
1.9
3.3
4.0
5.3
44
19
10
8
3
84
43
19
9
7
3
81
42
20
10
6
4
82
44
17
12
6
4
82
28
17
13
6
4
68
27
13
12
6
4
62
28
14
9
6
5
62
24
18
9
7
4
62
Sources: Left graph: BIS, IMF, US Federal Reserve, World Tourism Organization, Datastream, First Quadrant,
L.P. Data as of December 31, 2010; Right graph: Currency trading volume data is from April 30, 2013 BIS
Triennial Survey.
Russell Investments // Currency strategies and bond portfolios
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Corporations, commercial banks, equity and bond investors, currency managers, central
banks and tourists are the active participants in global currency trading. Participants can be
broadly classified as:
1.
Hedgers – Many global corporations systematically convert their foreign currency
revenues into their home currencies, to hedge their future international revenues/profits
and international assets/liabilities. Equity and fixed income investors may hedge the
currency exposures embedded in their international investments. Central banks are also
active participants as they hedge to manage capital and currency flows.
2.
Profit seekers – Currency managers, global bond managers, hedge fund managers and
commodities trading advisors (CTAs) are active participants, with profit-seeking
objectives.
3.
Dealers – Commercial banks provide liquidity and facilitate trading activities by acting as
intermediaries.
Despite the enormous average daily turnover, a large portion of the currency transactions are
not motivated by profit seeking. The hedging activity related to corporate treasuries and asset
management portfolio flows makes up the majority of the market’s trading volume. This group
of investors (asset managers) may be willing to pay a premium to accomplish their hedging
objectives. For this reason, profit-seeking currency managers, whose activities make up only
a relatively small portion of the market’s volume, believe there may be persistent inefficiencies
that can potentially be exploited in the currency market.
Currency Indexing
Because of their role as a financial intermediary, global commercial banks have an active role
in currency transactions as market makers providing liquidity and acting as trading partners.
They also provide currency market analysis and suggest trading strategies, and they have a
vested interest in generating trading volume and profits. To serve their profit-seeking clients,
the banks have expanded their services to include investable currency indexes. For the same
reasons investors use equity and bond indexes to passively invest in those markets, profitseeking investors can now use indexes to passively invest in currencies.
Currency indexes are constructed systematically to passively invest in baskets of currencies
with similar characteristics. Via these indexes, investors can gain exposure to a diversified
currency portfolio that is periodically rebalanced and regularly recalculated. Similarly to other
asset classes, currency returns can be related to and explained by various risk factors.
Among the currency factors, Carry (interest rate–based), Value (fundamental economics–
based) and Momentum (price-based) are the factors index providers most often include in
their currency indexes. Beta based on volatility (currency option–based) has started to
emerge, but has not been widely followed. A currency index provides benchmark exposure to
these systematic strategies.
The Barclays series of currency indexes includes the Barclays Intelligent Carry Index,
Barclays World Carry Index and Barclays World FX Trend Index (the latter selects the 24 most
trending currencies in developed and emerging markets). Citibank has the CitiFX Beta
Indexes series, with five core investment styles: G10 Trend, G10 Carry, Emerging Market
(EM) Trend, EM Carry, and G10 Purchasing Power Parity (PPP). Deutsche Bank offers the
DB Currency Carry Index, DB Trends USD Index, DB Value Index and the DBCR+ (the latter
includes EM currencies). J.P. Morgan offers its Emerging Local Markets Index Plus (ELMI+),
which tracks total returns for local currency–denominated money market instruments.
Russell Investments recently launched the Russell Conscious Currency® Index (RCCI) series,
an equal-weighted blend of Carry, Value and Trend factors in G10 currencies. We based the
currency analysis presented in this paper primarily on the RCCI index and its subcomponents. Each factor aims to represent a naïve benchmark or index, as explained below.
Russell Investments // Currency strategies and bond portfolios
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Currency Factors
Currency indexes attempt to capture the systematic risk premiums (currency beta) potentially
available in currency investing, and to enable investors to distinguish between the risk/return
produced with and without active management insight (alpha and beta). The performance of
these investment factors has been shown to explain currency returns.
Exhibit 4: Currency Factors
STRATEGY
CHARACTERISTICS
RATIONALE
TYPICAL FORMULATION
Carry
Interest rate-based strategy,
seeks to capitalize short term
interest rate differentials
High-yielding currencies tend to
outperform lower-yielding
currencies in the short and
intermediate term
Buy (long) high-yielding
currencies and sell (short)
low-yielding currencies
Value
Fundamental economics-based
strategy, looks for currency to
mean revert to its fair value
level
Currencies with strong
fundamental tend to outperform
over long horizon
Buy undervalued currencies
and sell overvalued currencies
Trend
Price-based strategy, utilizes
technical analysis tools
Currency markets exhibit a
tendency to trend over time
Buy (sell) currency when short
moving average moves above
(below) long moving average
Exhibit 5: Historical Risk and Return
December 1999 – December 2013
Growth of a dollar ($)
$2.4
$2.0
$1.6
$1.2
$0.8
Carry
Trend
Value
RCCI
CARRY
TREND
VALUE
RCCI
Annualized Std. Deviation (%)
8.73
8.77
7.97
4.57
Annualized Return (%)
2.19
0.73
2.24
1.98
Cumulative Return (%)
35.68
10.78
36.52
31.83
Source: As of December 31, 2013: Russell Investments
The returns provided for the RCCI includes data for periods prior to when the index was in live production.
Historical returns for these RCCI prior to the live production date are calculated using the same Russell
methodology; however, application to the performance calculation may vary due to data sources and the
availability of historical data with respect to certain currencies. Please contact the Russell Index Client Service
Team for further detail.
Russell Investments // Currency strategies and bond portfolios
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Carry Factor
In a Carry strategy, investors buy (long) high-interest-rate currencies and sell (short) lowinterest-rate currencies. Carry currency trades bear the risk of changing interest rates and
exchange rates. For example, if the 1-year interest rate in the U.S. is 0.70% and the 1-year
interest rate in Australia is 3.70%, a U.S. investor can enter into a one-year forward contract
by buying AUD and selling USD. The investor could potentially make money if the USD
appreciated less than 3% (3.70% minus 0.70%) against the AUD.
The popularity of Carry trades appears to contradict the uncovered interest rate parity (UIP)
theory, which states that high-interest-rate currencies are expected to depreciate relative to
low-interest-rate currencies. Yet academics and investment practitioners have shown that
currencies in countries with high interest rates tend to appreciate relative to currencies in
countries with low interest rates. This anomaly constitutes the term “forward rate bias,” with
the implication that investors can make systematic profits by selling (taking a short position)
the low-yielding currency and buying (taking a long position) the high-yielding currency.
In effect, the Carry factor equates to having exposures to short-term bonds, which are very
much influenced by changes in short-term interest rates, which are themselves influenced by
central banks’ monetary policies. Those policies may also significantly impact the asset risk
premium and cross-border capital flows.
In periods of relatively low volatility, Carry strategies can generate relatively stable returns.
However, Carry strategies are vulnerable during periods of increased market uncertainty and
in risk-off market environments as investors flee to safe-haven instruments. Thus, it is
possible for suddenly distressed market environments to induce sudden reversals in the Carry
strategy’s performance. This issue is amplified in emerging market countries, where the Carry
strategy has been a staple.
Active managers can potentially outperform via Carry strategies if they possess superior
ability to understand market volatility and risk sentiments and to anticipate central bank
policies.
Value Factor
A Value strategy will purchase (long) currencies that are undervalued relative to their “fair
value” and sell (short) currencies that are overvalued. Value strategies tend to have a long
investment horizon, because the speed of reversion of exchange rates to long-term
equilibrium levels, as estimated by “fair value” models, can be slow.
It is generally accepted that the Value strategy is based on the “law of one price” concept,
which states that in the absence of transaction costs, identical goods will have the same
effective price in different markets, regardless of the currencies in which that price is stated.
One of the oldest and most popular measures of currency fair value is “purchasing power
parity” (PPP), a theory concerning the long-term equilibrium exchange rates based on the
relative price levels of two countries. In its simplest form, a country’s PPP is simply a price
relationship that shows the ratio of the prices, in national currencies, of the same goods and
services in different countries. PPP theory also says that price differences between countries
should converge over time by exchange rate movements or by different speeds of inflation
that draw undervalued and overvalued currencies back to their “fair value.”
Another popular measure of relative value is based on the “balance of payments” (BoP)
model, which consists of current account (trade balance of goods and services, income and
current transfers), capital account (capital transfers, remittance, and acquisition/disposal of
non-produced, non-financial assets), and financial account (direct investment, portfolio
investment and reserve account). There are various factors that potentially impact BoP;
among them are changes in the exchange rate, a government's fiscal deficit, business
competition, excess domestic consumption and asset price inflation. A BoP surplus occurs
when the current account surplus is higher than the outflows in the capital accounts, resulting
in increased reserve assets. In BoP terms, a country’s currency appreciates when its BoP is
positive (“BoP surplus”) and depreciates when its BoP is negative. BoP is a transaction-based
approach, and thus it differs from the price-based approach in PPP. However, the two
approaches similarly seek to assess currency valuation on the basis of countries’ relative
fundamental economics.
Russell Investments // Currency strategies and bond portfolios
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Active managers can outperform in this strategy by developing superior valuation models that
incorporate supplementary or proprietary blends of factors. Also, instead of making a naive
investment in a currency that is over-/undervalued, based on current relative rankings, active
managers may have opportunities to outperform by timing their trades so that they pursue
opportunities only when they are most attractive. That a currency is the most undervalued
relative to other currencies doesn’t mean it can’t become even more undervalued. Active
managers can outperform with trades made closer to an inflection point.
Trend Factor
The basic assumption in a Trend strategy is that the expected distribution of next period’s
return is not necessarily independent of historical returns. In other words, information
extracted from time series of historical returns may help to “predict” the expected distribution
of next period’s return. This “momentum effect” is believed to explain some of the movements
in the currency market, as well as in equity, bond and commodity markets. Due to their focus
on price, Trend strategies rely more on technical analyses than on the fundamental
economics of countries.
Trend strategy involves buying currencies that have experienced high historical returns in like
market conditions and selling currencies that have had low or negative historical returns in like
market conditions. A simple implementation of a Trend strategy is to buy when the currency
level is above a simple arithmetic moving average, and to sell when it is below. The
relationship between economic theory and empirical evidence to explain the Trend factor is
not well defined. Clear patterns in currency movements may be signs of a country’s economic
growth (or contraction) and thus of potential benefit to practitioners of the Trend strategy.
Trend strategy tends to perform best when markets evidence a persistent trend and worst
when markets are “choppy” in tight and range-bound conditions. Active managers can
outperform in this strategy by more accurately detecting when a trend is about to start or end,
and by not being fooled by false signals. Managers need to consider effective responses to
changes in market volatility and to be able to time entry/exit points well, as information
diffusion becomes more efficient. Many active currency investors tend to de-emphasize the
momentum effect in markets that are relatively less liquid.
Currency as a Portfolio Diversifier
Unlike global fixed income investors, U.S. fixed income investors have been generally
underexposed to foreign currencies. The abundance of USD-denominated investment
vehicles, including Yankee bonds1 has not moved most U.S. investors to seek exposures to
foreign currency–denominated opportunities. We believe investors who exclude global
currencies from their portfolios may be missing out on potential diversification benefits.
Investors may find that currency indexes’ historical returns, and the low correlations between
currency and mainstream asset classes suggest an attractive strategy for consideration.
Clearly, currency strategy analysis is much simpler at the single-asset level than at the multiasset level. We believe investors who want to add currency strategies to their portfolios
should consider porting them atop their existing index (beta). The unfunded nature of currency
strategies (either passive or active) facilitates their implementation as overlay exposures
through the use of derivatives.
The currency strategies represented by RCCI and its sub-indexes embody the characteristics
of currency market views, and over the last 10 years, currency has had a low to negative longterm correlation with both fixed income and equity (Exhibit 6). Hence, currencies may play a
valuable role not only in a fixed income portfolio, but also in a multi-asset portfolio. Historically,
the Agg index has had low correlation with currency strategies, with Trend and Value showing
negative correlations. However, the Carry sub-component does have high positive correlation
to credit spreads and equity risk.
1
Bonds denominated in U.S. dollars that are publicly issued in the U.S. by foreign banks and corporations.
Russell Investments // Currency strategies and bond portfolios
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Exhibit 6: Correlation between currency factors and asset classes
December 2003 – December 2013
RCCI RCCI Value Momentum
RCCI
RCCI Carry
Barclays
Agg
IG Credit
Emerging
US High
EMD Hard EMD Local
Market
Yield Bank Loan Currency Currency Currencies
Russell Russell EM
1000
Equity
RCCI
1.00
RCCI - Value
0.40
1.00
RCCI - Momentum
0.52
-0.14
1.00
RCCI - Carry
0.53
-0.14
-0.16
1.00
Barclays Agg
-0.11
-0.07
-0.18
0.07
1.00
IG Credit
-0.04
-0.27
-0.16
0.32
0.80
1.00
US High Yield
0.00
-0.37
-0.23
0.53
0.20
0.62
1.00
Bank Loan
0.01
-0.27
-0.25
0.49
-0.07
0.37
0.85
1.00
EMD Hard Currency
0.02
-0.35
-0.25
0.55
0.63
0.80
0.74
0.50
1.00
EMD Local Currency
0.07
-0.20
-0.10
0.35
0.62
0.64
0.43
0.09
0.76
1.00
Emerging Market Currencies
0.10
-0.42
-0.18
0.65
0.26
0.45
0.59
0.40
0.68
0.52
1.00
Russell 1000
0.16
-0.28
-0.19
0.64
0.02
0.35
0.73
0.62
0.57
0.35
0.68
1.00
Russell EM Equity
0.20
-0.32
-0.17
0.71
0.14
0.46
0.73
0.58
0.69
0.46
0.80
0.81
1.00
Sources: Barclays, J.P. Morgan, Russell Investments; see Appendix for list of indexes used
Another way to look at the potential diversification benefits of adding currency to a fixed
income portfolio is through the lens of “efficient frontier analysis,” which incorporates
information about historical risk, return and correlation among sectors. Such analysis is not
meant to provide guidance on future expected levels of risk and returns, but can indicate the
diversification ability of currency strategies. The starting point of this analysis is our
assumption that a fixed income investor will have exposure to the Agg, to high yield (HY) and
to emerging market debt (EMD). By incorporating currency strategies into the mix, we found
that the combined portfolio produced higher expected return for a given level of risk relative to
a portfolio without currency strategies. Because the exposure to currency can be achieved on
an unfunded basis, a modest gearing in the currency exposure at 150% (Exhibit 7) elevates
the RCCI risk level closer to the other asset classes and accentuates the efficient frontier
movements.
Carry is positively correlated with credit and emerging market debt. Hence, the bulk of the
diversification benefits can be gained with exposure to just the Value and Trend factors. One
can also gain similar level of diversification benefits using the RCCI. However, because the
RCCI includes the Carry factor, the optimal portfolio adjusts by having less exposure to credit
sensitive sectors, such as HY.
Exhibit 7: Efficient Frontier
Annualized return (%)
December 1999 – December 2013
10
8
6
4
2
3
4
5
6
7
Annualized standard deviation (%)
BCAgg+HY+EMD
BCAgg+HY+EMD+Value+Trend
8
9
10
BCAgg+Hy+EMD+RCCI
RCCI
VALUE
TREND
CARRY
BARCLAYS
AGG
HY
EMD
Annualized Return (%)
5.92
5.49
2.27
8.02
5.62
7.89
10.00
Annualized Std. Deviation (%)
6.86
11.96
13.16
13.09
3.60
10.27
9.47
Russell Investments // Currency strategies and bond portfolios
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Sources: As of December 31, 2013: Barclays, J.P. Morgan, Russell Investments; see Appendix for list of
indexes used. Note: RCCI, Value, Trend and Carry returns are geared 1.5x
Exhibit 8: Currency and Credit Correlations
Rolling 3-year correlation with
credit excess
December 2003 – December 2013
1.2
0.8
0.4
0.0
-0.4
-0.8
Carry
Trend
Value
RCCI
Sources: Barclays Capital, Russell, as of 12/31/2013. Note: Correlations are to the returns of the Barclays US
Credit Index excess of equivalent-duration treasuries
In addition to diversifying credit risk, currency is a natural diversifier to interest rate (duration)
risk. Unlike traditional U.S. bond investments, global currency strategies do not have a direct
fundamental relationship with the U.S. Treasury’s yield curve. Economies across the globe
have different business cycles. Coming out of the global financial crisis, they typically recover
at different speeds. Due to these varying growth rates, interest rates and inflation levels will
differ, and currencies will strengthen/weaken at different times. This enables practitioners of
currency strategies to seek return streams that are not fundamentally tied to U.S. interest
rates. Thus, with the potential rate rises on the horizon and the Agg’s being less well
positioned for rate rises, investors may find the diversification properties of currency strategies
attractive.
For example, in the last 10 years, the most significant Fed funds rate hike occurred between
June 2004 and June 2006, when rates increased from 1.00% to 5.25%. Over this period, the
RCCI outperformed the Agg by approximately 44 bps.
Exhibit 9: Fed Funds Rate Increases and Currency Factor Performance
Fed funds target rate (%)
7
6
5.25
5
4
3
2
1
1.00
0
June 2004-June 2006 Returns (%)
RCCI
CARRY
TREND
VALUE
AGG
6.99
9.28
-1.04
12.58
6.55
Source: As of March 31, 2013: Bloomberg, Federal Reserve Bank, Barclays, and Russell Investments
Russell Investments // Currency strategies and bond portfolios
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Investors also have the option to address rate rise concerns by simply reducing the duration
risk in their fixed income allocations. For example, one may allocate a portion to cash, floating
rate investments (e.g., bank loans) and/or short-duration bonds. Currencies differ from these
funded alternatives in that currency exposure can be obtained synthetically with currency
forwards, using existing fixed income holdings as collateral. Hence, implementing a currency
strategy does not preclude the use of other interest rate–defensive strategies.
Active Currency Strategy
Fixed income investors may find currency strategies attractive due to currency’s low
correlations with interest rate and credit risk, particularly when the strategy is implemented by
adding currency strategies with a beta overlay.
Passive or systematic strategies provide a convenient, low-cost exposure to currency factors,
as ample currency liquidity helps to minimize transaction costs and management fees.
However, dedicated active currency management is also a reasonable alternative. As
previously suggested, significant presence of non profit-seeking oriented participants in the
currency markets may make for persistent inefficiencies that profit-seeking investors can
exploit.
Significant aspects of currency managers’ investment processes can be observed in their
investment styles (outlined in Exhibit 10), which differ from processes in the currency index.
The blend between investment styles and currency factors is manifested in the products
offered by the currency managers. Both Carry-based and Value-based managers are focused
on fundamental analysis; however, they are differentiated by their processes, which can be
systematically rules-based or discretionary. Most of the Momentum- and Trend-based
managers typically follow rules-based processes; however, some managers also follow
discretionary processes to over-rule the trading.
Exhibit 10: Active Currency Manager Investment Style
Quantitative
model and
fundamentalbased analysis
with rule-based
execution
Technical: pricebased analysis
with rule-based
execution
Fundamentalbased analysis
with discretionary
execution
Technical: pricebased analysis
with discretionary
execution
Technical
Fundamental
Quantitative
Discretionary
Ideally, performance for active currency managers is compared to their respective currency
factor, however, most managers in Russell’s currency universe utilize multiple factors and are
not easily classified. In recent years, the performance of active currency managers in the
Russell’s currency universe has been mixed. The collapse of the Carry trade in 2008 resulted
in significant drawdown, and for many active currency managers, the sudden spike and
secular decline in the volatility level afterward made for a challenging environment.
Russell Investments // Currency strategies and bond portfolios
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Currency’s episodic return patterns and inherent volatility, and the negative correlations
among currency factors, suggest that employing multiple factors and following multiple
investment styles may potentially be more fruitful than relying on a single factor or single
investment style. As currency markets are driven by various elements, combining a mix of
manager skills in fundamentals, technicals and market timing may be a prudent diversification
strategy. Access to a broad currency investment universe, including emerging currencies, is
becoming more important for active currency strategies, even given the relatively high trading
costs and limitations on capacity.
The number of active currency managers is on the rise, and currency has attracted interest
from hedge funds, CTAs, and traditional fixed income firms. Active currency strategies are
vulnerable to systematic risk, as are strategies in other asset classes, and during market
crises they may not deliver the diversification benefits investors had expected. However, as
the termination of global monetary easing policies draws closer, the currency market may be
entering into a period of increased volatility that could yield opportunities for active managers
to outperform. Currency is, after all, one of the few asset classes wherein active managers
tend to benefit from elevated levels of volatility.
Conclusion
In our view, given that currency risks/returns are driven by factors that differ from those of
bonds, the addition of currency exposure, either passive or active, has the potential to make a
positive impact on the overall performance of a combined portfolio. The factors most
commonly used to explain currency behavior are Carry, Value and Trend. The Russell
Conscious Currency Index is comprised of equal weight exposure to each of those factors.
REFERENCES
Aggarwal, R., B. Lucey and S.K. Mohanty (2006). “The Forward Exchange Rate Bias Puzzle: Evidence from New
Cointegration Tests.” Institute for International Integration Studies (Discussion Paper), Dublin Trinity College.
Nasypbek, S., and S. Rehman (2011). ”Explaining the returns of active currency managers.” (BIS Papers: No. 58), The
Bank for International Settlements, Monetary and Economic Department.,
Bilson, J., and D. Cernauskas (2003). “Currency and Credit Markets.” Melbourne Business School.
Burgi-Schmelz, A. (2009). “Balance of Payment and International Investment Position Manual” (sixth edition). International
Monetary Fund.
Dorsey, A., et al (2013). “Recovery in Developed Market Currency Volatility – An Antidote to Bond Market Interest Rate
Risk.” Neuberger Berman.
Henry, S., B. Ingram and J. Mitchell (2007). “Understanding Active Currency Management.” Russell Investments.
Hafeez, B. (2007). “Currency Markets: Money Left on the Table?” In “Deutsche Bank Guide to Currency Indexes.” Deutsche
Bank.
Gyntelberg, J., and A. Schrimpf (2011). “FX strategies in periods of distress.” The Bank for International Settlements
Quarterly Review.
James, J., I. Marsh and L. Sarno (2012). “Handbook of Exchange Rates.” John Wiley & Sons, Inc.
The Bank for International Settlements (2010). “Triennial Central Bank Survey.”.
Kulp, A., et al. (2005). “Managed Futures and Long Volatility.” AIMA Journal (February).
Pojarliev, M., and R. Levich (2008). “Do Professional Currency Managers Beat the Benchmark?” Financial Analysts Journal;
vol. 64, no. 5, pp. 18–32 (September–October).
Siourounis, G. (2003). “Capital Flows and Exchange Rates: An Empirical Analysis.” London Business School.
“Russell Conscious Currency Index Series” (2013). Russell Investments. See
http://www.russell.com/indexes/data/currency/russell-conscious-currency-indexes.asp.
Toner, I. (2010). “Conscious Currency: A new approach to understanding currency exposure.” Russell Investments.
Russell Investments // Currency strategies and bond portfolios
11
Appendix
Indexes used in Exhibits 6 and 7 are:
Russell Conscious Currency Index (RCCI) including RCCI – Value, RCCI – Momentum, RCCI
– Carry. Barclays Aggregate Index for Barclays Agg; Barclays Investment Grade Credit Index
for IG Credit; Barclays US High Yield Index for US High Yield (HY). Credit Suisse Leverage
Loan Index for Bank Loan. J.P. Morgan Emerging Market Bond Index Global Index for EMD
Hard Currency; J.P. Morgan Global Bond Index Global Diversified Index for EMD Local
Currency; J.P. Morgan ELMI+ for Emerging Market Currencies. Russell 100 Index for Russell
Index and Russell Emerging Market Composite for Russell EM Equity.
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First used: February 2014
USI-18861-02-17
Russell Investments // Currency strategies and bond portfolios
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