Introduction:

Investors’ perceptions of value and momentum in the context of currency portfolio development involve multiple facets. In the realm of forex, four popular factors are acknowledged: the dollar risk factor, the carry trade factor, the currency momentum factor, and the currency value factor. The dynamic conditional correlation copula (DCC-copula) model with skewed-t kernel has been found effective in fitting the joint distribution of these factors.

For equity investments, value and momentum are regarded as less risky compared to other factors like size and beta. This contradicts the risk factor hypothesis, which posits that investments with higher expected returns should carry higher risk. Financial professionals and analysts, in a controlled experiment, perceived value and momentum stocks as less risky but held higher return expectations for momentum stocks, questioning the traditional risk–return trade-off belief.

The broader investment literature suggests that, on average, value stocks (defined by low valuation measures like price-to-earnings ratios) tend to outperform growth stocks, and stocks with high positive momentum (indicating a continuing upward price trend) outperform those with low positive momentum. However, it’s important to note that momentum tends to be a short-term phenomenon and often reverses over the long term. Fama and French, notable academics in the field, acknowledge the existence of momentum in stock prices but argue that its effect is short-lived, usually lasting only a few months, and the transaction costs associated with frequent trading can negate the abnormal returns.

Combining value and momentum strategies is seen as a highly effective investment approach. Studies have shown that these strategies, when combined, yield strong returns over time and exhibit a negative correlation with each other. This negative correlation is beneficial as it reduces the downside volatility of the portfolio, smoothing out returns. The combination of value (low price to book value) and momentum (12-month price appreciation) strategies has been consistently effective across various markets, with the exception of Japan. Interestingly, a 50/50 combination portfolio of value and momentum strategies tends to perform best, largely due to the negative correlation between these strategies.

Additionally, the concept of “Trending Value,” formulated by James O’Shaughnessy, combines value and momentum characteristics in stock selection. This approach involves first screening for value stocks based on low valuation criteria and then selecting those with the highest six-month price momentum. This methodology has been backed by impressive back-tested performance, suggesting that value stocks with some price momentum are not merely value traps with deteriorating businesses but are companies on the path to recovery, as indicated by their emerging price momentum.

In conclusion, investors perceive value and momentum as integral components in portfolio development, with their combination proving particularly effective in delivering strong, risk-adjusted returns. These strategies, when applied thoughtfully, can enhance diversification and performance, especially in turbulent market conditions.

Successful Currency Portfolio Development Strategies

1. Momentum-Based Strategies: In currency markets, momentum strategies involve following existing market trends and taking positions in currencies that have shown strong recent performance. These strategies capitalize on the continuation of current trends, generating profits in trending markets but may face challenges in range-bound or choppy markets​​.
2. Value-Based Strategies: These strategies focus on identifying undervalued or overvalued currencies based on fundamental analysis, such as economic indicators, interest rates, and inflation data. The aim is to profit from the eventual convergence of currency values to their fair value​​.
3. Combining Value and Momentum: Research indicates that combining value and momentum strategies can be more beneficial than using them independently. For example, a study showed that for concentrated factor portfolios, a 50/50 allocation to a Value portfolio and a Momentum portfolio historically yielded higher returns than a portfolio that combines the Value and Momentum signals together​​​​.
4. Currency Momentum Factor: The momentum strategy, initially discovered in equity markets, is also a robust anomaly in the currency market. It involves buying assets that have performed well in the past and selling those that have underperformed. Academics have documented significant cross-sectional spreads in excess returns of up to 10% per annum between past winner and past loser currencies​​.
5. Sequential Ranking in Combining Strategies: Another approach to combining value and momentum is sequential ranking. This involves ranking stocks first on value and then on momentum within the value-ranked stocks, and vice versa. This method has shown historical success, with sorting stocks on value and then momentum (or the reverse) improving risk-adjusted returns compared to simple momentum investing​​.

It’s important to note that while these strategies have shown success historically, they require careful implementation and consideration of current market conditions. Additionally, frequent rebalancing, especially in momentum strategies, can lead to higher transaction costs.

Strategies for Weighting Value and Momentum in Currency Portfolio Development

Investors determining the appropriate weighting for value and momentum in their currency portfolio development consider several factors and approaches. The process involves understanding and applying the concepts of carry, momentum, and value strategies, which can differ in their application based on time-series (absolute) and cross-sectional (relative) perspectives.

For momentum weighting, investors might use percentile ranks as a means of weighting the portfolio. This method divides each asset’s percentile score at a given time by the sum of all scores at that time, resulting in a distribution of portfolio capital proportional to an asset’s momentum rank score at each rebalance period. Momentum weighting has been shown to improve upon equal-weight baselines, enhancing metrics across various indicators and providing an average boost in annualized returns, improvements in Sharpe ratio, and a reduction in maximum drawdown.

However, the use of momentum alone may not be sufficient. The magnitude of the momentum signal, while correlated with better performance, does not provide significant information about relative returns between top-performing assets. A more nuanced approach might involve overweighting assets in the top half of a distribution and underweighting those in the bottom half.

In contrast, a study on value and momentum investing suggests that for concentrated factor portfolios, a 50/50 allocation to separate value and momentum portfolios historically yielded higher returns than a portfolio that combines the value and momentum signals together. This holds true in both U.S. and international samples. However, as the number of stocks in the portfolios increases, the return differential between separate and combined signals gets closer. When examining risk-adjusted measures like the Sharpe ratio, neither the separate nor combined approach demonstrates a clear advantage.

The decision between separating or combining value and momentum strategies depends on various factors. Historically, more concentrated portfolios have shown higher returns with the “Separate, then combined” approach compared to the “Combined-signal” portfolio. This methodology also allows for a better understanding of the returns post-investment, as the two factors are kept separate.

In conclusion, the choice of strategy for weighting value and momentum in a currency portfolio involves a balance between these factors and the consideration of risk-adjusted measures. The decision can vary based on the size and type of the portfolio, the market, and the investor’s specific goals and preferences.

Measuring Effectiveness of Currency Portfolio Strategies

Several methods are used by the investors to gauge the effectiveness of different currency portfolio development strategies. Some key performance indicators include:

1. Absolute and risk-adjusted returns: These metrics assist investors in determining the total profitability of their currency strategies, accounting for the involved risk.

2. Consistency of performance: This stability in approach makes investors look for strategies that generate positive returns consistently over time.

3. Comparison against benchmarks or peer groups: This enables investors to know whether their currency strategies outperform relevant indices or other strategies.

4. Sharpe ratio: It compares a portfolio excess return with respect to the portfolio’s standard deviation. Sharpe ratio is a measurement of a better risk-adjusted performance.

5. Drawdowns: Moreover, investors have an avenue for assessing the maximum drawdowns their currency strategies have faced, giving them an indication of the risk downside and the strategy’s ability to recover.

Such performance metrics allow the investors to assess the performance of their currency portfolio development strategies and improve its risk-adjusted returns.

Conclusion

In conclusion, currency portfolio development is a multifaceted endeavor that incorporates various strategies, including value, momentum, and their combination. Investors in both currency and equity markets recognize the potential benefits of these approaches in pursuit of higher returns and risk management. Value and momentum strategies, when applied thoughtfully, have demonstrated their effectiveness in delivering strong risk-adjusted returns. The combination of these strategies, particularly in equity investments, has shown the potential to reduce downside volatility and enhance portfolio performance.

In the currency market, momentum-based strategies capitalize on existing trends, while value-based strategies aim to profit from currency value convergence. Combining value and momentum in currency portfolio development can provide an advantage, as historical data suggests. The choice of weighting value and momentum depends on various factors, including portfolio size, investor goals, and market conditions. Investors can use different methods, such as percentile ranks or a 50/50 allocation, to determine the most suitable weighting strategy.

Measuring the effectiveness of currency portfolio strategies is crucial for investors. Metrics like absolute and risk-adjusted returns, consistency of performance, benchmark comparisons, Sharpe ratio, and drawdowns help investors assess the performance and risk profile of their strategies, allowing them to make informed decisions and optimize their currency portfolio development efforts.

Disclaimer: This is not an Investment Advice. Investing and trading in currencies involve inherent risks. It’s essential to conduct thorough research and consider your risk tolerance before engaging in any financial activities.