Do Professional Currency Managers Beat the Benchmark?

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...24 percent of the managers were able to generate positive and significant alpha between 2001 and 2006. The average alpha of these "star" managers has been quite high and significant at 104 bps per month or 12.48 percent per year.

Over the last twenty years, the notion of currency as an asset class has gained a wider following. Inspired, perhaps, by numerous studies reporting profitability in various types of currency trading strategies, investment consultants have promoted currency products as a potential source of alpha, or returns above a certain benchmark. This interest is reflected in the fact that the number of funds in the Barclay Currency Trader Index (BCTI) has grown from 44 in 1993 to 106 in 2006. While returns on the BCTI (an equally-weighted composite of managed programs that trade in currency futures and forwards) were initially in the healthy double-digit range, those returns have tended to diminish over time, especially over the last few years.

In Do Professional Currency Managers Beat the Benchmark? (NBER Working Paper No.13714), authors Momtchil Pojarliev and Richard Levich investigate which factors help to explain currency traders' returns and the returns for individual currency managers. They show that four factors, representing four styles of currency investing, explain a significant part of these returns. The average excess return of the BCTI index was positive at 25 basis points (bps) per month between 1990 and 2006. However, once the authors account for these four factors, the alpha is actually negative at -9 bps per month and not statistically different from zero. As the authors point out, this is not encouraging news for currency managers.

There are some interesting differences between the 1990s and the post-2000 period. First, volatility was not a significant factor in the 1990s, but it is significant after 2000. This may be related to the increase in options turnover in the most recent years. Second, the average excess return in the 1990s was 36 bps per month, but after 2000 the average excess return declined to only 8 bps per month. However, in both periods currency managers were not able to generate a positive alpha on average. Despite all the talk that the recent years have been more challenging for currency management, the authors have witnessed a decline only in the beta returns. The average alpha has remained almost the same: -16 bps per month in the 1990 and -11 bps per month after 2000.

This is not all bad news for currency managers. The authors show that 24 percent of the managers were able to generate positive and significant alpha between 2001 and 2006. The average alpha of these "star" managers has been quite high and significant at 104 bps per month or 12.48 percent per year. Importantly, this 104 bps alpha is measured after taking into account the four explanatory factors, carry, trend, value, and volatility, the first three of which reflect returns on naive currency trading strategies. According to the authors, this demonstrates that currencies have similarities with other asset classes whose returns can be related to risk factors. Although the average manager might under-perform, there are some skilled managers who are able to deliver significant alpha.

The results of this research support the notion that the foreign exchange market offers opportunity for alpha generation. However, the authors suggest that greater emphasis should be put on active currency management. Their model makes clear that all returns generated by currency managers are not pure alpha. A significant part of currency returns comes from exposure to a small set of factors that proxy the returns from well-known and easily implemented trading styles. This realization may lead to some re-pricing for "active" currency products. It will be difficult to justify a 2 percent management fee and 20 percent performance fee for exposure to currency style betas when exposure to equity style betas might be gained for 3 to 10 bps.

The authors also suggest that the recent lackluster returns from currency managers are the result of declining beta returns stemming mainly from the declining profitability of trend-following rules and not the result of declining alpha generation. Their research shows that alpha generation has not declined after 2000 in comparison to the 1990s. Delivering alpha has never been an easy task, which may explain why investors might be willing to pay high fees for true alpha performance. An index of currency managers tended to under-perform in the 1990s and post 2000. However, some skillful managers have been able to deliver positive and significant alphas.

-- Les Picker