Momentum trading strategies in foreign exchange markets yield “striking” excess returns of up to 10 per cent a year, according to a new study.
‘Cross-sectional strategies’ – where investors go long or short on a basket of currencies based on their past performance – yield the highest returns, even when accounting for transaction costs.
The findings come from a new study, due to be published in the Journal of Financial Economics, which analysed 48 currencies against the US dollar from 1976 to 2010. The research provides the most comprehensive analysis of momentum risk and returns in currency markets to date.
“We find large currency momentum strategies yield surprisingly high unconditional excess returns of up to 10 per cent per a year,” says co-author, Professor Lucio Sarno (pictured) of Cass Business School. “These returns are particularly striking given they persist in currency markets characterised by sophisticated investors, huge trading volumes, an absence of short-selling constraints and considerable central bank interference.”
Given how easy it is to set up a momentum strategy, a natural question is why arbitrage does not wipe out returns? The authors argue that while currency momentum profits are attractive, they are by no means a free lunch for investors.
The study showed that successful momentum portfolios in foreign exchange markets were significantly skewed towards minor currencies which have relatively high transactions costs, accounting for between 30 and 50 per cent of momentum returns.
Profitable investment portfolios also required buying and selling currencies with high volatility at the right time, such as those of emerging markets countries like Brazil, South Africa or the Philippines.
“Highly idiosyncratic movements of a currency make it harder for potential speculators to hedge their positions,” Professor Sarno said. “This hampers the exploitation of momentum profits and is an important factor in explaining the persistence of momentum returns in FX markets.”
Momentum strategies built around currencies of countries with higher economic, political and financial risk also yielded significant excess returns, whereas momentum strategies in countries with low risk ratings did not.
“Investors must select currencies of risky countries with less stable exchange rates to profit from momentum strategies. This is especially important since, unlike momentum strategies in domestic US stocks, investments in foreign currency are always subject to the risk that sudden introduction of capital controls prevents repatriation of capital for foreign investors.”
The findings also showed momentum returns are far from constant, even over medium time spans of several years. Therefore, an investor seeking to profit from momentum returns must have a long enough investment horizon.
This is important since the bulk of currency speculation is accounted for by investment professionals who have a short time span over which their performance is evaluated.
Since FX players, such as proprietary trading desks, asset managers and hedge funds, generally have short investment horizons, the large time-variation in momentum profits hampers arbitrage activity in FX markets.
Professor Sarno concluded: “Investment professionals are attracted to momentum strategies because of their strong performance over long periods of time, but obviously do not execute momentum strategies to a degree that the returns are wiped out.
“This may be explained by the considerably high transaction costs and to a greater degree by several limits to arbitrage: returns to momentum trading are subject to high time-variation, favour ‘risky’ countries and involve currencies with high idiosyncratic volatility.”