The application of smart beta to currency management

Most of the discussion of smart beta so far has focused on the management of equity portfolios. At the recent Russell Institutional Summit, Keith Brakebill described how the concept is being extended to currency markets.

“Smart beta” is really factor exposure management…

I am in the camp that defines smart beta as factor exposure management. In other words, it’s about the conscious management of exposures that are less than asset classes, but more than individual securities, i.e. factor exposures such as capitalization or quality or momentum and so on.

The management of factor exposures is not really new, but it is a greatly expanded world thanks to advances in analytics and a broader set of investment instruments (ETFs, futures, other derivatives.) These mean that “factors” no longer just refers to capitalization and value and growth, but now includes hundreds of possibilities.

…and factor exposure management can be used in currencies, too

And the idea does not just apply to equities. In his presentation, Keith described three factor exposures that can be identified in currency markets. "Value" can be likened to the equity market’s value factor, and is based on the tendency of currencies to revert toward long-term purchasing power parity. "Trend" is very similar to equity's momentum factor, and based on the tendency of currency movements to persist. And, finally, “carry” favors those currencies that offer higher interest rates, based on the tendency of those currencies to offer higher total returns.

The historical track record of each of these factors is good: annualized returns of 3.81%, 1.62% and 5.15% respectively for value, trend and carry from November 1999 through March 2015¹. There are good reasons to believe that each of those three factors is likely to continue to offer positive returns over time, although, as with any factor exposure, there are no sure things—and the attractiveness of each factor can vary significantly over time.

So the application of currency strategies in active portfolios requires skill and a sound process. As has often been observed: smart beta is only smart when it’s in the right hands. In short, as with all factor exposures, these are good tools, but success depends on the skill of the user.