Articles from Cass Knowledge

Swept along by currencies

Momentum investing can be a winning strategy in foreign exchange but the risks may be too high, according to research by Professor Lucio Sarno at Cass. Steve Lodge reports.

Momentum investing can be a winning strategy in foreign exchange but the risks may be too high, according to research by Professor Lucio Sarno at Cass. Steve Lodge reports.Momentum investing - buying what has performed well and selling what has done badly - has proved a profitable strategy for equity traders.

This trend-following approach, which is based on the assumption that recent performance is more likely to continue in the same direction than to reverse, has also been found to work in other markets - even currencies, an asset class that some see as especially difficult to predict.

In fact, foreign exchange markets show as large a momentum effect as equities, according to Currency Momentum Strategies, researched and written by Lucio Sarno, Professor of Finance at Cass Business School; Lukas Menkhoff, Professor of Economics at Leibniz University, Hanover; Maik Schmeling, Assistant Professor of International Money and Finance at Leibniz; and Andreas Schrimpf, Economist at the Bank for International Settlements.

In an analysis of 48 currencies over various timeframes between 1976 and 2010, currencies which had recently strengthened went on to gain up to ten percentage points more, extrapolated as a yearly figure, than those that had weakened.

Trading in a crisis
The study also found that momentum returns did not correlate with those from the so-called carry trade - the most popular foreign exchange trading strategy whereby investors borrow in currencies with low interest rates to invest in those with higher rates.

Professor Sarno says: "There's a great deal of benefit in diversifying away from the carry trade - momentum is a hedge.
"Carry trades do very badly in a crisis [as investors push up the value of "safe haven" currencies with lower yields], while momentum does well in bad times. It offers a different source of profits."

But why does the momentum effect exist at all? And if it is such easy money, why - given that foreign exchange is the most liquid of markets populated by professional traders with the incentive to exploit the strategy - hasn't it been arbitraged away?

Bandwagon effect
As with momentum in other markets, investor psychology is seen as playing a part, specifically the common tendency for under or over-reaction. Exchange rates are often slow to respond to news as traders process information. Then, once currencies do start to shift, traders frequently over-react, creating a bandwagon effect which adds to the movement.
The research also found that most of the momentum profits in foreign exchange came from the less liquid currencies of emerging markets, including the Brazilian real, the South African rand and the Philippine peso, rather than the dominant currencies such as the US dollar, the euro, or sterling. This means higher trading costs as well as higher risks for those seeking to capture the effect, which in turn limits arbitrage activity. Costs for transactions between two of the more exotic currencies can be ten times the cost of transactions between major currencies.
Momentum involves regular portfolio rebalancing, and the most profitable strategies in foreign exchange are short term, where currencies are bought and sold according to movements in the past month. This raises turnover and, therefore, expenses. Overall, about a third of returns are lost in costs.
Investors will also be exposed to countries with specific political or macro-economic risks - and therefore potential exchange rate instability or convertibility problems.

Waiting game
Profits can also vary significantly in the short term. Momentum traders need to be prepared for extended periods of loss. Asset managers, however, may not be able to play the waiting game. The study says: "As a three-year window is often seen as the maximum period an unsuccessful asset manager can survive, the application of currency momentum trading is clearly risky."
Moreover, the relative illiquidity of emerging market currencies means that large funds looking to trade momentum are at risk of moving prices against themselves. Professor Sarno, who is routinely called for foreign exchange advice by organisations such as the US Federal Reserve, the European Central Bank and the International Monetary Fund, says:"The biggest funds will have problems investing in the lesser currencies - the ideal fund would be small."
He points out that while there are exchange traded funds (ETFs) that exploit currency momentum and offer trend-following strategies for low management fees, these cover only the currencies of the G10 economies, where the effect has been much less apparent. Deutsche Bank's X-trackers Currency Momentum ETF, for example, underperformed the group's less specialised Currency Returns ETF - which invests a third each in momentum, carry trade and value strategies - in 2009 and 2011.
George Saravelos, a foreign exchange strategist at Deutsche Bank, acknowledges that emerging market currencies show a greater inclination to follow trends, but notes that there are still concerns about their liquidity and tradability.
Professor Sarno says that currency momentum should be seen as "compensation for risk" rather than a market anomaly. The research draws parallels with momentum in equities and corporate bonds, where studies have shown the effect is concentrated in shares with high credit risk and in non-investment-grade corporate debt. "It's not a free lunch: to generate these higher returns, investors need to take higher risks," he concludes.

Currency Momentum Strategies, by Lukas Menkhoff, Lucio Sarno, Maik Schmeling and Andreas Schrimpf,forthcoming in the Journal of Financial Economics

Steve Lodge is a freelance financial journalist. He can be contacted at