Do Professional Currency Managers Beat the Benchmark?

Investigation of an index of returns on professionally managed currency funds and a subset of returns from 34 individual currency fund managers finds that over the 1990–2006 period, currency fund managers earned excess returns averaging 25 bps per month. The study examines the relationship of these returns to four factors that represent the returns from distinct styles of currency trading—carry, trend, value, and volatility. The four factors explain a substantial portion of the variability in index returns. The study’s approach modifies the definition of alpha returns to only that portion of excess returns not explained by the four factors. The impact of this change on measured alpha is substantial, but some currency fund managers still generate alpha returns. Since the 1990s, the notion of currency as an asset class has gained a wide following. Inspired, perhaps, by numerous studies reporting profitability in various types of currency-trading strategies, investment consultants have promoted currency products as a potential source of alpha (or returns above a certain benchmark). This interest is reflected in the growth of the number of funds in the Barclay Currency Traders Index (BCTI)—from 44 in 1993 to 106 in 2006. If currency is indeed an asset class, we should be able to identify a set of factors that correlate with managers’ realized returns from currency investment. In this article, we report our study of the extent to which currency managers’ returns correlate with four factors that are intended to represent feasible benchmark returns from distinct styles of currency trading—carry, trend, value, and volatility. We examined monthly data for the 1990–2006 period and calculated that excess returns earned by currency managers in the BCTI averaged 25 bps per month. Our results also show, however, that a substantial part of currency returns (both for the overall index and for 34 individual currency managers) can be explained by systematic exposure to the four basic trading strategies (i.e., style betas). Once we accounted for these four factors, our estimate of alpha actually became negative (–9 bps per month) and not statistically different from zero. We examined the stability of these relationships over time and found that both carry and trend strategies played a significant role in the 1990s. After 2000, however, the impact of the carry factor increased somewhat whereas the impact of the trend factor declined. Nevertheless, the trend factor has remained the most dominant factor in terms of R2. It has explained more than 65 percent of the variability of the excess currency returns since 1990. In the 1990s, currency manager returns were, at the margin, significantly negatively related to the value factor, meaning that currency managers as a group tended to bet against purchasing power parity and were worse off for it. After 2000, currency manager returns became positively and significantly related to the volatility factor. In summary, after 2000, nearly 77 percent of the variability in monthly returns on the BCTI can be explained by our four factors. The results for individual managers are, naturally, more diverse than the results for the overall index. In the six-year period ending in 2006, 8 of 34 currency fund managers produced statistically significant excess returns (returns over and above the returns associated with the four factors) that averaged about 104 bps per month. Although overall managed currency returns have declined sharply in the recent period, some individual managers were still capable of generating alpha in relation to our four-factor model. Our approach significantly alters the definition and measurement of alpha returns in the context of currency speculation. For various reasons (e.g., currency returns alleged to be unpredictable or uncorrelated with equity benchmarks), most studies have adopted zero for currency overlay programs and the risk-free return for absolute-return programs as the appropriate return benchmarks for currency speculation. In prior studies, all excess returns were classified as alpha returns (i.e., beta returns were assumed away). In our framework, alpha currency returns are those over and above returns associated with transparent and readily implemented currency-trading strategies. We show that our framework can significantly alter the ranking of individual managers on such performance measures as the information ratio. As exchange-traded funds become available to proxy the returns from basic currency-trading strategies, investors can capture these returns (i.e., beta returns) with minimal cost. In our framework, professional currency managers who simply mimic the strategies embodied in our four factors are unlikely to earn alpha. Our empirical results support this finding; they show a significant inverse relationship between alpha returns and the variation explained by the four factors. This realization may lead to some repricing for “active” currency products. Funds will have difficulty justifying alpha fees for exposure to currency style betas that could be earned more cheaply.