Foreign Exchange: The Risk-Based Alternative
by Patrick Oberhaensli, on Apr 10, 2020 4:45:00 PM
It's not expected that a long-only passive investment will offer satisfactory returns for either a USD versus a set of key currencies or a EUR/USD (an EUR investment expressed in USD). This is especially true when considering the level of risk taken due to the current importance of the EUR within the investment.
This isn’t a surprise to many investors, but it does not mean that alpha generation through a truly active approach in FX should be ruled out. And that is precisely what we will illustrate in this article.
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The long-only passive approaches of FX
The investment profiles for the USD versus a set of key currencies and EUR/USD long-only passive that are presented in the chart below clearly show that the returns over a (past) long period are very weak if not negative in absolute. In addition, returns are very poor relative to the risk taken expressed in maximum drawdown (the volatility is not worth more than being an indicator). The negative Sharpe Ratio summarizes this point well when looking at the single currency pair exposure EUR/USD.
For the period starting end of March 2007 up to the 12th of December 2019, including specific costs, we see the following results for a USD long-only passive investment.
And for the EUR/USD long-only passive (capitalized) for the very same period:
It should be noted that for both markets, the maximum drawdown is far away from what is typically experienced with developed equities (there, the maximum drawdown would be in the 55 to 60% range). In this sense, returns are much too low considering the risk.
Now, let’s have a look at really active strategies for the very same markets… With no surprise the improvements are strong.
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The active risk-based approach of FX – considering shorts as well
Let's consider an innovative risk-based approach for the USD versus a set of key currencies and the EUR/USD. We will look at an approach that is able to exploit short positions but doesn’t aim to recognize trends.
For the period starting end of March 2007 up to the 12th of December 2019, including specific costs, we see the following for the USD long/short/out close-to-zero beta at the same risk as the USD long-only – in terms of maximum drawdown
And for the EUR/USD long/short/out zero beta at the same risk as the EUR/USD long-only (capitalized) – in terms of maximum drawdown for the very same period:
The very low and zero beta respectively show the high diversification effect with both the USD long-only and with other traditional (large) asset classes. The main reason for this effect is that the risk inputs also come from the traditional markets. This also allows a dynamical approach that’s based on less efficient indicators and parameters.
In terms of returns, they are now at a level that is consistent with the risk taken. The percentage of positive monthly returns have also increased by 10% (relative) versus the long-only investments. And finally, the Sharpe Ratios are both well above the +0.50 level – a figure that is already considered as “good”. It is also noteworthy that the more diversified USD long/short/out active strategy has an even higher ratio.
Forex strategies need to be updated in order to satisfy the requirements of the investors in terms of performance. As illustrated here, the risk-based approach is clearly one of the possible concrete ways for investors to increase returns at a level consistent with risk.
EVOLIDS FINANCE LLC, Disclaimer:
- This content is not intended to be a solicitation nor an offer
- The preparation of the information provided herein is done with a high level of care. Nevertheless, errors are possible