Investment-style benchmarks such as value
investor, growth or quantitative identify
money management approaches in every giant investment sector
with one glaring exception: the $4 trillion foreign exchange
marketplace. Forget dozens of terms that money managers use to
compare performance in equity and fixed-income markets. In
currency markets the chief benchmark is zero. At the end of the
day, traders either make money or they dont.
The status quo needs to change, especially now, say authors
Richard Levich at NYU Stern and Momtchil Pojarliev at
Hathersage Capital. Investors mindful of risks and hefty costs
often a 2 percent management fee and 20 percent of
excess profits deserve to know which currency managers
really deliver their moneys worth. A landscape with
scarce returns adds urgency.
If currency managers are charging a substantial
management fee, Levich says, can you replicate
their strategy with simple currency trades in most
money-management tool kits? The new paper fine-tunes
their evidence that three basic ways to manage currency
portfolios dominate most outcomes in currency markets, and any
skilled money manager can replicate them.
Historically, currency trading has resisted style
comparisons. Experts have trouble just agreeing that currency
merits status as an asset class akin to stocks, bonds or real
estate. Investors who own stocks, or gold, or a treasury bond
can point to underlying assets. Whats the
underlying in currency? says Levich. For that matter,
where is the annual meeting? How do investors vote their
proxies? Where are the financial statements?
Such is the debate that a senior currency trader at FXDD
declined to tell Institutional Investor through the
firms public relations person whether in his view
currency constitutes an asset class.
Unlike more traditional asset classes, unseen and capricious
forces play havoc with currency markets. Investors get
the jitters for good reason, says Levich. Fundamental
values are elusive. Central banks intervene in ways that equity
markets would never tolerate. Trading systems for executing
currency transactions clear through a separate set of
institutions, currency traders operate with unique rules and
informed monitors are sorely lacking even if they knew exactly
what to look for.
Levich and Pojarliev separate currency traders into
beta grazers who settle for returns commensurate
with going risk premiums and alpha hunters who
capitalize on market inefficiencies and behavioral bias. (Wall
Street analyst Marty Liebowitz coined both terms.) Hence the
provocative title of their new research paper: Hunting
for Alpha Hunters in the Currency Jungle.
The authors report that three currency trading styles
account for a whopping two thirds of the outcome: carry, trend
and value. Carry strategies bet that any depreciation by higher
yielding versus lower yielding currencies wont outweigh
interest differentials. As its label implies, trend strategies
bet that currencies that have appreciated most will continue in
the same direction. Currency traders who employ value
strategies figure out which currencies are overvalued and sell
them (or borrow in them) to buy undervalued currencies.
Consider two actual but undisclosed managers who produced
3.7 percent and 3.2 percent in annualized excess returns.
Despite a bottom line separated only by 50 basis points, carry,
trend and value lenses revealed striking differences. The three
basic strategies produced nearly all of the returns that
manager number one posted. That makes him a beta grazer who
brings little to the table.
For manager number two the story is quite different.
His trading strategy was not related to any of those
three conventional sources, say Levich. Essentially
all of manager twos returns are coming for reasons other
than conventional strategies. Hes doing something we
cant explain by looking at three factors.
Translation: Manager two is an alpha hunter worth a premium
Does it really matter how two managers get to similar
results? Indeed it does, Levich argues. Would you as an
institutional manager rather have 3 percent profit from a guy
uncorrelated with what is going on than 3 percent profit from a
guy that is correlated? The guy with uncorrelated risk will
reduce overall error with a better chance of offering returns
when everybody else isnt.
Hazy definitions makes differences hard to discern.
When a beta grazer disguises himself as an alpha hunter,
he reaps the economic benefit of charging hunting
fees for grazing, the co-authors report.
Levich and Pojarliev did not fire the first salvo in an
ongoing debate. Writing last fall in the Journal of Portfolio
Management, BlackRock directors Michael Melvin and Duncan Shand
expressed skeptical views about style differentiation in
currency markets. It is fine if people want to use them
but the need to be clear about the shortcomings of any
particular measure, Melvin told Institutional Investor.
These words sound somewhat more conciliatory than more fiery
language in JPM last fall, where he and Shand declared that
the simple use of style factors in currency investing is
fraught with dangers and is of limited use as a benhmark for
Levich, who directed this reporter to Melvin for a
countervailing view, believes history is on his side. Style
analysis has been a standard practice for hedge fund selection
for a long time, he says. Its time that currency trading
benchmarks caught up. Sifting beta grazers from alpha hunters
using three basic strategies takes a purposeful step in that