The foreign exchange market: A great place for systematic strategies

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Please note that this article may contain technical language. For this reason, it is not recommended to readers without professional investment experience.

Please note that this article contains technical language. For this reason it is not recommended to readers without professional experience of this topic.

 

Foreign exchange markets are inefficient by nature, given that they are used mainly for commercial reasons by companies and retail investors and for the exchange rate policies of central banks. This inefficiency can be a windfall for investors seeking attractive returns and diversification in their financial investments. We see systematic strategies as an excellent way to exploit the inefficiencies of foreign exchange markets.

Foreign exchange futures and forward currency transactions are among the instruments that we believe are best suited to setting up systematic strategies – sometimes also known as “factor investing” or “smart beta” strategies.

However, paradoxically, currencies are not a true asset class like equities or bonds, as they are normally not bought to be held, but, rather, for the immediate use that can be made of them.

– For example, you may need US dollars if you are going to buy an apartment in Miami or even if you are just planning a holiday in Las Vegas. Such projects are not completely the same as buying an apartment in Sydney or planning a holiday in Macao.
– Companies also need to invest abroad, and such investments are rarely interchangeable from one country to another. For example, it is difficult, time-consuming and costly for companies to switch production from one country to another.
– Central banks, which can heavily influence foreign exchange markets, often have reasons for buying a currency other than the mere hope of making a winning investment.

It is precisely because the foreign exchange market is so atypical that it is an attractive environment for systematic strategies, for at least two reasons.

The first is the liquidity. Due to huge and universal demand, foreign exchange markets offer outstanding liquidity on the main currency pairs with, moreover, the ability to trade 24/7 with very narrow bid/ask spreads.

The second reason is a direct corollary of the aforementioned characteristic, i.e. that holding currencies is not the ultimate objective of many buyers. This creates inefficiencies in the market.

For example, if we consider solely those investors who trade currencies to boost the returns of their portfolios, the foreign exchange market can be considered especially attractive, because it is not a zero-sum game!

For proof, look no further than the fact that strategies as simplistic and universally known as carry trade, momentum and value have been quite profitable for many years and are still widely used.

– The FX Carry Trade strategy consists of buying currencies with the highest interest rates and shorting those with the lowest interest rates
– The FX Momentum strategy focuses on currencies that have recently appreciated the most
– The FX Value strategy focuses on currencies that are below their intrinsic value, measured, for example, in terms of purchasing power parity

Exhibit 1: The daily performances of the Russell RCCI (Russell Conscious Currency Index), whose objective is to replicate such strategies and to aggregate them, (30 November 1999 to 31 December 2014):

RCCI

Source: Russell Conscious Currency Index Series, as at 25 November 2015

Moreover, these three basic strategies have a very low correlation with one another. As the table below shows, their correlations, calculated over the same period on the basis of daily returns, are very low.

Exhibit 2: The correlations of the Russell RCCI (30 November 1999 to 31 December 2014)

RCCI2

Source: Russell Conscious Currency Index Series, as at 25 November 2015

It should be noted that these are not the only strategies that can be envisaged for application in foreign exchange markets. They can be used in conjunction with other strategies. Research in this area is still being undertaken worldwide. The subject is vast and goes well beyond the scope of this article.

What we wanted to emphasise in this article is the atypical nature of the foreign exchange market and what it can offer to long-term investors. Systematic strategies offer them, in our view, the prospect of attractive returns and, even within this investment category, significant diversification.

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Bruno Crinon

Quantitative Analyst

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