Using diversification in currency portfolios and cutting edge allocation methodology, alternative investment managers believe they can create alpha. The ongoing quest for alpha must be kept in harmony with the foreign exchange manager’s goal of creating the highest returns attainable while minimizing volatility. Achieving these goals is quite challenging in the currency trading arena as the choices are very limited. With only ten mature currencies and about twenty choices from emerging areas, the menu of selections is quite restricted.
As with a loan portfolio, a loan officer would rather have a portfolio with 100 loans than one with 10 loans, to reduce risk and smooth out profit streams. Likewise, a fixed income manager is much more likely to achieve more consistent returns with much lower risk, with a 100 bond portfolio instead of one containing only 10 bonds.
Therefore, currency fund managers, who can somehow construct true portfolio diversification, have a much better opportunity to deliver higher returns, information ratios, and longer term stability to their investor group.
If one can achieve appropriate diversification, the subsequent step becomes the “allocation factor.” Effective diversification in currency portfolios is usually a mix of creative trading styles, a variety of currency pairs, and even, time horizon diversity.
A critical factor in designing a profitable trading strategy is the relentless examination and pursuit of all profit sources of the given market.
Currency, while possessing superb liquidity, has not been considered a true asset in the normal “buy and hold” or “buy, hold, then sell” mentality of most investment portfolios.
Therefore, dealing in foreign exchange is a unique, but quite inefficient market area. FX managers understand the base return – the “beta” – in the foreign exchange market is created using the historical data of “rules-based strategies” that cater to the inherent inefficiencies of the currency market.
Trading strategies are also somewhat restricted. Directional trading and carry trading are the most popular strategies to generate the beta. A lesser used approach uses “volatility space” to identify mis-pricings that could generate positive returns.
Many believe that, since unsophisticated rules-based strategies often generate good returns in the currency market, an effective fund manager should have the expertise to add “alpha” to the assumed beta. On paper, alpha contains three primary components: Thoughtful portfolio development, intelligent risk management, and accurate model construction.
Most model designers believe the most critical factor affecting the success of the alpha components is allocation. After developing a menu of trading systems, FX managers must integrate them into a portfolio that capitalizes on the diversification component of the portfolio and the lack of correlation among the models.
Elementary theory dictates that a combination of strategies, based on the components previously described, should consistently perform better than any single strategy approach. The low correlation among the models greatly modifies the risk. Many effective FX managers expand on this approach, using multiple systems-on-systems to generate returns higher than merely using one set of multiple systems.
As FX traders further enhance portfolio complexity, they look more and more like managers of a fund of funds. Their focus becomes concentrated on the allocation among strategies and generating the right mix. This, of course, assumes the strategies were sound in the first place.
As the portfolio becomes more complex, the “allocation alpha” gains new importance. At times, the alpha becomes more important than a particular strategy to the success of the returns. Hence, managers must carefully and intelligently allocate their risk capital throughout their strategies.
If the target is truly to generate better returns than can be achieved with a portfolio containing a “naïve allocation” construction, managers must develop ways to achieve this goal. The allocation function, already proven to increase returns when combined with effective trading models, is also critical in constructing a more dynamic portfolio.
The driving forces that affect the performance of the portfolio strategies must be understood and smartly controlled. The manager must know the conditions under which the strategies project over-performance and when they tend to dictate under-performance.
For example, some strategies are directed toward long volatility, which makes it likely they will over-perform in “divergent” market periods, while those targeted to neutral or short volatility conditions should over-perform in “convergent” market periods.
Therefore, in the pursuit of turning beta into alpha, the dynamic and strategic allocation approach is now considered a major driver of positive returns. In the currency trading world, allocation will always also be a primary source of risk.
If managers can continue to create effective trading strategies, they can utilize dynamic allocation techniques to achieve excess returns in the currency market while mitigating the inherent risk.