Download Currency factors: More than a zero sum game

Currency factors:
More than a zero sum game
Van Luu, Ph.D.
Head of Currency and Fixed
Income Strategy
Joseph Hoffman, CFA
Director, Global Head of
Currency
Russell Investments has undertaken considerable research into currency factors and has created
transparent rules-based strategies for three of the strongest factors: carry, value and trend. In the current
post-quantitative easing (QE), low-return environment, we believe investors should consider adding
currency factor exposures to their multi-asset portfolios. Such so-called “smart beta” strategies can help
to enhance returns with modest or no additional risks, given the low correlation of currency strategies to
traditional asset class strategies. In this paper, we look at:
1. Three smart currency factors: carry, value and trend
2. Putting the Russell Conscious Currency® Index (RCCI) strategy into practice
3. Current client adoption of the RCCI strategy and use of bespoke or dynamic factor weightings
4. Russell Investments’ research into development of a rules-based, dynamic factor-weighting approach
Executive summary
In the current post-QE world, expected returns from the
traditional asset classes of equities and bonds are low.
Investors continue to seek ways to improve their multiasset portfolios – more dynamic allocations, more focus
on diversity and how to seek out opportunities less
familiar to “the crowd”. Investors are also re-examining
their balance between active and passive management
and the increasing use of “smart beta”; long-term
portfolios that are expected to diversify and outperform
market cap approaches.
Within these discussions, currency is often an
afterthought and its management is often overlooked.
Some investors simply believe that currency is a zero sum
game and can be ignored. Others view it as difficult to get
a cost effective strategy that adds value. However we
have found opportunities to enhance portfolios through
“smart”, low cost, rules based approaches to currency
exposure that seek strong uncorrelated returns.
Russell Investments // Currency factors: More than a zero sum game
Frank Russell Company owns the Russell trademarks used in this material. See “Important information” for details.
MARCH 2016
There is widespread academic support showing currency
factors can offer valuable, persistent and relatively
uncorrelated return sources. We have undertaken a broad
array of research to uncover ways to benefit from different
currency factors. This has led us to create transparent
rules-based strategies for three of the strongest factors –
carry, value and trend. These have fundamental
foundations, strong empirical evidence and academic
support. Furthermore, the returns of these factors have
offsetting characteristics, which make them more effective
as a group than individually.
As the largest and most liquid financial market in the
world, the currency market offers investors a number of
low cost approaches to implement rules-based currency
strategies:
 As part of their currency overlay program (adjoined to a
partial or fully hedged program)
 As an absolute return strategy (as a discrete portfolio
allocation)
These currency strategies have low correlations to
traditional assets and thus can enhance multi-asset
portfolio returns with modest or no additional risk. So for
us it becomes obvious that, in the current post-QE, lowreturn world, investors should seek to add currency factor
exposures to enhance their returns.
Three smart currency factors: Carry, value
and trend
have been shown to generate significant positive average
returns at moderate volatility over decades. The
fundamental rationales for these returns are:
 Carry captures the tendency of higher interest rate
currencies to earn higher returns than lower interest rate
currencies as a compensation for higher risk.
 Value takes advantage of the tendency of currencies to
mean-revert to a level of long-term economic
equilibrium, such as purchasing power parity (PPP).
 Trend exploits the propensity of currency returns to
persist over horizons of several months so that past
returns have some predictive power for future returns.
The academic support for each of these factors is broad
and extensive. For example, Doskov and Swinkels (2014)
show that the carry strategy would have generated
positive returns since 19001.
To create a suitable portfolio strategy from these
individual currency factors, we then created the Russell
Conscious Currency® Index (RCCI) as an equally
weighted composite of carry, value and trend. Exhibit 1
plots the cumulative percent return of the currency
factors. Each of these in isolation has experienced
periods of significant negative returns. However, these
drawdowns do not often occur at the same time. A
combination of the three currency factors as captured in
the RCCI strategy achieves a better balance of return to
risk with much shallower drawdowns.
There are a number of characteristics that can be used to
describe the economic aspects of a currency – such as its
interest rate, the cost of a basket of goods in that currency
or its returns in the recent past. If these characteristics of
different currencies can be grouped together, we can
consider these economic aspects as currency factors.
Historical returns are not a guarantee of any future
performance but have been quite compelling. The RCCI
strategy has earned an annualized return of 3.6% per
year between Nov. 30, 1999 and Dec. 31, 2015. Given
annualized volatility of 4.5%, the reward-to-risk ratio is an
attractive 0.8. The occurrences of negative yearly returns
are relatively shallow, not exceeding -4%.
Our research has looked at ways we can capture
currency factors across the developed (G10) countries’
currencies and the return profiles of such factors. Based
on this work and the broad-ranging academic support, we
have identified carry, value and trend as strategies that
Finally, the historic RCCI strategy returns have had low
correlations to traditional assets, with correlations of 0.26
to global equities and -0.09 to global bonds, which could
be very attractive within multi-asset portfolios.
Exhibit 1: Cumulative percent return of the currency factors
Cumulative percent return
150%
100%
Carry
RCCI Composite
50%
0%
Value
Trend
2008 was very
volatile, but value and
trend compensated
for the severe decline
in carry, resulting in
only a slight drop for
the Composite
-50%
Source: Russell Investments. December 1999 through December 2015.
Russell Investments // Currency factors: More than a zero sum game
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Putting RCCI into practice
The currency market is the largest and most liquid
financial market in the world and offers significant
capacity to implement currency factor strategies with low
implementation costs. There are a number of different
ways that institutional investors can approach the
implementation:
 Part of the currency overlay program: Many
investors seek to hedge all or part of their currency
exposures through an overlay program. Rather than
taking a passive approach, the RCCI strategy can be
incorporated within the overlay, so that now the funds
take conscious control of the currency factors they want
to be exposed to, retaining those that are expected to
have a positive long-term return.
 An absolute return strategy: The strong historical
risk/return ratio, low drawdowns and low correlations to
traditional assets make the RCCI strategy attractive to
consider as a diversifying portfolio allocation to absolute
return strategies. In this case, investors access the
strategies and their benefits as a direct allocation and at
considerably lower costs than other absolute return
strategies. 2
In both cases, the strategies are implemented with
currency forwards, which are considered an efficient use
of capital. This allows the rest of the portfolio to remain
invested in equities, bonds and other long-only asset
classes with minimal or modest impact to the rest of the
portfolio.
Adding RCCI to a global balanced portfolio
Since currency factor strategies do not need to be funded,
we can add an overlay of 20% of the portfolio value to a
typical multi-asset portfolio with 60% in global equities
and 40% in global fixed income without reducing the
allocations to the traditional asset classes.
In Exhibit 2, we compare the return and risk
characteristics of the balanced portfolio without and with
the 20% currency overlay. The annual return is raised by
70 basis points while portfolio volatility increases slightly
from 8.6% to 8.8%. The return-to-risk ratio improves from
0.55 to 0.61 with similar peak-to-trough drawdowns.
Russell Investments // Currency factors: More than a zero sum game
Exhibit 2: Adding RCCI to a balanced global
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portfolio
November 30, 1999 to December 31, 2015
BALANCED
BALANCED
GLOBAL
PORTFOLIO (60/40)
WITHOUT
CURRENCY
GLOBAL
PORTFOLIO
WITH 20%
CURRENCY
OVERLAY
Portfolio returns pa
4.7%
5.4%
Portfolio volatility
8.6%
8.8%
Return-to-volatility
0.55
0.61
Portfolio drawdown
-32.1%
-32.3%
Source: Bloomberg, Thomson Reuters Datastream. Balanced global
portfolio (60 Equities/40 Bonds)
Similar benefits occur when using the RCCI as an
absolute return strategy.
Current client adoption and use of bespoke or
dynamic factor weightings
Since 2013, interest in these strategies has been rising
and we already manage over $2bn as of December 31,
2015 in our Conscious Currency strategies. To date,
most of our clients have implemented currency factors
through our equally weighted RCCI strategy. These
clients have appreciated the academic support and longterm investment rationale of the currency factors. They
appreciate the transparency, simplicity and low cost
nature of the implementation.
Investors can also explore bespoke weightings to target a
more specific role in the portfolio. Some of our fixed
income portfolio managers use allocations with lower
exposure to carry, as their current portfolios already had
exposure to risk factors with positive correlation to carry,
such as credit.
Finally, our current area of research is the development of
a rules-based, dynamic weighting approach for the
different currency factors. We vary the allocation to the
carry, value and trend factors over time based on the
prevailing risk environment. Preliminary results show that
a dynamic version of the currency factor portfolio can
achieve higher returns than the statically weighted one
without an increase in risk when combined with equities
and bonds. We are looking to make this available to
clients later this year.
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Conclusion
In the current post-QE, low-return world, we believe
investors should take a smart approach to their currency
exposures within their multi-asset portfolios and consider
how they can use them to enhance returns. There is
strong empirical and academic evidence to show that the
currency factors of carry, value and trend can be a
valuable, persistent and relatively uncorrelated return
source.
Historically, the RCCI strategy has earned an annualized
return of 3.6% per year between Nov. 30, 1999 and Dec.
31, 2015 with an annualized volatility of 4.5%. Over this
period, a 20% currency overlay allocation to a global
balanced portfolio would have added almost 0.7% to
returns with negligible impact on the total risk.
For interested investors, there is also the opportunity to
consider the direct interaction with their portfolios and
make bespoke allocations to the underlying currency
factors to gain potentially greater efficiencies.
1
Doskov, Nikolay and Laurens Adrianus Petrus Swinkels. Empirical
Evidence on the Currency Carry Trade, 1900 -2012. Journal of
International Money and Finance, November 2014.
2
Zigler, Brad. Can we Count on Absolute Returns? Wealth
Management, August 19, 2014.
http://wealthmanagement.com/etfs/can-we-count-absolute-returns
3
Global Equities are measured by the total return of the MSCI World
Index in USD-hedged terms. Before December 2001, we
approximate the total return index by adding dividends to the price
index of the MSCI World Index USD hedged. Global bonds are
measured by the total return of the Barclays Global Aggregate Index
in USD-hedged terms. Currency overlay is the return index of the
Russell Conscious Currency Index. Portfolio weights are rebalanced
monthly.
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and services, which include advice, investments and implementation. Russell Investments stands with institutional investors,
financial advisors and individuals working with their advisors—using our core capabilities that extend across capital market
insights, manager research, asset allocation, portfolio implementation and factor exposures to help investors achieve their
desired investment outcomes.
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Call Russell Investments at 800-426-8506 or
visit www.russellinvestments.com/institutional
Important information
Nothing contained in this material is intended to constitute legal, tax, securities, or investment advice, nor an opinion regarding the appropriateness
of any investment, nor a solicitation of any type. The general information contained in this publication should not be acted upon without obtaining
specific legal, tax, and investment advice from a licensed professional.
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First used: March 2016 (Disclosure revision: August 2016)
Russell Investments // Currency factors: More than a zero sum game
RIS-2775 (03/19)
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