Game Changers: From Keynes to Currency Factors

Henning Stein:                   

Jordan Maynard Keynes was one of the most important game-changers in the history of economics and finance. It's now nearly a century since his findings really revolutionized economics. Today, we are meeting another Cambridge academic whose work is changing how we think. And in addition, we have a practitioner who can explain to us how to implement these findings.

So factors are changing how we view asset management. They represent an investment approach that targets quantifiable characteristics that really help to explain patterns of risk and return. So, today we are discussing their role really in the context of currencies. And I'm joined by David Chambers. He's the Academic Director of the Centre for Endowment Asset Management at the Judge Business School. And David is really responsible for especially innovative research in his field.

But also with us is Jay Raol. He's a director of Quantitative Research at Invesco Fixed Income. Jay will help us really place some of today's insights into a more tangible risk and asset allocation framework for investors. David, you are the first researcher together with your co-authors of this paper—I have it here, Currency Trades—to really examine the long-run evidence on the existing of factors in currency markets. And could you explain why this long-run evidence is important in this context and what are the main conclusions in terms of really simple terms for practitioners like us?

David Chambers:              

Thank you, Henning. So, the main purpose of this paper is to examine one of the most important issues when you're thinking about factor investing, irrespective of whether it's in currencies or equities, or fixed income. And when you're thinking about what factor exposures and investing you want to take on, it's really important to understand how robust those factors are in terms of the risk premia or the returns that they generate.

Now, much of the research that has been done both by academics and practitioners to try and identify the factors that are out there is based on data that starts from around 1980. So, it's a reasonable length of time, but it still only amounts to barely four decades. And it's also a period of time that is dominated largely by one macroeconomic narrative, which we've come to know as the great convergence. And that represented the period from the early '80s through to the global financial crisis where saw a steady decline in interest rates.

And that proved to be a relatively benign environment for a lot of investors. So, what we're doing in this paper is to say, to really understand how robust a factor is in terms of the risk premia returns that they can generate, we need a lot more data. Now, we could wait from where we are today for the markets to reveal more data for us going forward, but you're going to have to wait a long time. So, the other thing that we can do is go back in time and find as much high-quality data as we can and conduct what academics would call an out-of-sample test. So, in other words, we take the same risk factors or factors that have been established in a recent research on recent data sets and look at how they behave in this out-of-sample period. And over this much longer span of time.

And in doing that, we're adding more data, but we're also looking at how these factors behave in different economic conditions. And in particular, if you think back to the '20s and the '30s that was a very different set of macroeconomic conditions to what we have witnessed during the so-called great convergence.

Now in this paper, we particularly, look at the carry factor in currency markets and that's because probably of all the factors that are out there, carry is the one that's the most popular and the most well-known and at least in the last four decades, has fairly, consistently delivered positive returns. And what we find in the paper is when we look out-of-sample that, indeed, the carry factor still delivers positive returns, particularly in the period of the '20s and the '30s when we had a regime that was largely dominated by floating exchange rates. And so that result can give us some degree of confidence that carry is a robust factor. It doesn't mean it's going to perform well in all time periods and in all market conditions. And so these returns or risk premia will time-vary. And so a fluctuate-

Henning Stein:                   

And if I read this correctly, you're also talking about the switch. You examine what happens if you switch from a fixed to a floating currency regime and you used the 2015 Swiss Franc/Euro example to really show how breakdown of that currency pax is associated with significant carry trade losses. And what does this mean for investors in practical terms if they find themselves in, let's say, a global flight to safety, which we saw that in 2015?

David Chambers:              

That's correct. The episode that you're referring to in January 2015, the Swiss National Bank announced that they were going to drop the peg or the cap that they add for their currency against the Euro. And in the month following that announcement, the carry trade lost 5%. So, it experienced a very sharp loss. And that was because the long portfolio of the carry trade, the currencies, the high-interest rate currencies you're investing in a depreciated, but more importantly, in this case, the short portfolio of the carry trade or the currencies that you're using to fund your positions appreciated.

And what we were interested in doing was looking at how common this outcome was. So, one of the other great advantages of using this long span of 100 years of data that we now have on currency markets and returns is that there were a lot of regime changes of this nature.

So, there were a lot of instances of currency switching from fixed to floating and vice versa, but we're particularly interested in this fixed-to-floating event. And we have over 200 of these kind of events. And we were able to establish that on average, the carry strategy experienced losses in the month following these events, these so-called peg collapses or fixed-to-floating events. And so the message for the investor is that this is an additional type of risk that you're taking on when you're entering into the carry strategy in currency markets. Well, certainly, they would not previously have been aware of because this has not been unearthed by academics previously.

Henning Stein:                   

Right. And let's briefly return to Keynes. So, you mentioned that earlier, he obviously was a giant in the annals, you could say, of economics and finance. And usually, an extremely successful investor, but not so great with currency trading. Why was that?

David Chambers:              

It's interesting you raise John Maynard Keynes because the book that you have in your hand, he wrote coming up for 100 years ago today. He wrote it in New York in the autumn. This is The Economic Consequences of the Peace. This is probably the most entertaining of the books that he wrote because there isn't a lot of economic theorizing in there, but it's important in the context of what we're talking about today. Because the royalties he earned from that book, which sold very well, funded his currency speculation initially.

He began speculating in currencies in September 1919. Right at the end of World War I. And it was that. It was researching into his currency trading that put us on to the fact that there was actually a forward market that had started up in London. And this is the very first time. From that point on, we observe forward rates being consistently quoted on a daily basis.

And we went out and collected that data alongside spot rates. And it's that dataset that has enabled us to do the research that we've done today.

Now, the other interesting point that you raised is that he wasn't terribly successful speculating in currencies. He did actually make money overall. So, he made profit. But in the two episodes that he was managing his own money in the currency markets, he experienced two really substantial losses. One was in 1920 where, in fact, he was close to being personally bankrupt. And the other was again in the 1930s.

His approach to investing in currencies had nothing to do with factors. So, he pursued what today we would call a discretionary-fundamentalist-based approach, where he was looking at the macroeconomic and industrial data, and what was happening at the various central banks in trying then to decide what his fundamental take was on a currency. Whether to go long or short. And as I say, there's no evidence that he had exposure to factors, certainly, not explicitly. And even implicitly, when you model the returns on his portfolio, we can observe factor exposures. Would his performance have benefited from implementing a more of a carry strategy? Well, in the '20s and '30s, yes, it probably would.

Henning Stein:                   

Jay looking at this from a broader asset-allocation perspective, how do you see factors such as carry really aiding asset allocation?

Jay Raol:                               

Well, let's take a look at sound guiding principles for any asset allocation. First and foremost, risk control through diversification. Second, tilting the portfolio to premiums. Third, being very cost-efficient and fourth, transparent.

I think the benefit of factor investing is that it hits all of those criteria. Factors tend to have low correlations to themselves and to bonds and stocks. And therefore, they can provide diversification to a portfolio. As David said, factors like carry are rewarded in the long run. So, holding these kinds of portfolios are means to harvest returns. Because of their nature, they are very transparent. It's very clear the investment process behind factor investing. And finally, because of all those, they tend to be available at a very, very low cost.

Henning Stein:                   

And what motivated you to really start looking into carry factors specifically, and why is this really relevant to investors, you think?

Jay Raol:                               

Well, for us, the carry factor, as David said, is extremely popular, especially in fixed income. And a lot of the facts around carry are generally based off a shorter period of history than even he mentioned earlier. Carry underperformed quite dramatically in 2008 and had a severe drawdown. And since then, has struggled to produce compelling returns. And so, one of the things that we wanted to look at is the long history to understand whether there was returns there and is the risk profile that we saw in 2008, indicative of how carry's performed in past market crashes.

Henning Stein:                   

So, David Mentioned earlier, the Keynes strategy didn't have anything to do with factors. But you, obviously, said something I found quite intriguing is everyone's a factor investor, whether they realize it or not. And this raises sort of, I think, important questions for investors, such as which factors they should really have exposure to and how should they pay for them and applying this idea to what we've discussed today. So, how much currency exposure do you think should a reasonable factor asset allocation have and how much should investors be prepared to actually pay for it?

Jay Raol:                               

Well, I think one thing that David's work should highlight is that factors exist in all asset classes.  While people may be used to hearing about them in in equities, really, they can be found in all asset classes and many managers already implicitly or explicitly tilt toward factors. So, first and foremost, as you pointed out, investors should be looking at their portfolios, understanding what their factor exposures are. And as we said earlier, factors should not be expensive. And so in so much as investors have exposure to these factors, they should not be overpaying for them. That's first.

Second, in particular, currencies can be quite attractive for investors because first, the research shows that the carry factor, for example, has low correlations to stocks and bonds, and therefore they can provide a source of diversification, risk control, and return in the portfolio. Second, they're extremely liquid, probably one of the most liquid ways to get access to factors relative to equity factors or credit factors. And that can be very useful tool for asset allocators who want to be able to keep a part of the portfolio in a very liquid format, but also to harvest returns.

I think the one thing that David's research points out though is that monetary policy regimes can have an impact on these currency factors and, therefore, we advise that clients shouldn't use too much of them in their portfolio, but enough to provide a little bit of diversification.

Henning Stein:                   

So, if everyone's a factor investor, you said, whether they know it or not, do you think Keynes somehow appreciated the concept, even though he focused on fundamentals? Probably for you, David, the question.

David Chambers:             

I think there's not much evidence of that in what he did with his currency investing.  But there is evidence of that in what he did when he invested in equities. So, the detailed research we've done on his equity portfolios clearly shows that he had exposures to two important factors in equity markets, which are size and value. And so we can clearly see that he loaded on those factors. He had positive exposures to both those factors. Now in the 1920s, neither Keynes nor anyone else talked about factors, neither did they talk about size and value, but he clearly understood what he was doing in biasing his portfolios towards small companies and in biasing them towards companies that were cheaper than the average stock listed on the market. So, in equities, in short, he did expose the portfolio to the factors.

Henning Stein:                   

Thank you, David, thank you, Jay, for sharing your insights. And thank you for watching, and please look out for other videos on our Game Changes series.