Can We Replicate Active Currency Manager Returns? Open Access
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Despite extensive literature on exchange rates, few academic studies have provided an in-depth analysis of active currency managers. Historically, large commercial banks dominated currency trading. However, by 2007 hedge funds became major players in the foreign exchange (FX) market (BIS, 2007). Fung and Hsieh (1997, 2004, 2006) proposed a methodology to replicate the performance of various hedge funds using a set of simple investable trading strategies. Binny (2005) and Middleton (2005) formulated the groundwork for the most widely used active currency trading strategies. The primary research question in this study is: "Can we replicate active currency managers' performance using clearly formulated currency trading strategies, also called currency betas?" The historical returns of 200 active currency managers for the period from 1993 to 2008 are evaluated to see if it is possible to: (a) explain returns of active currency managers using simple trading strategies in the historical sample, and (b) replicate individual manager returns out-of-sample using an optimal combination of simple trading strategies. Rolling regressions and Kalman filters are used to build an active currency replication index-fund; its performance is then compared with the equal-weighted currency beta portfolio and optimized currency beta portfolios using classical Markowitz and Bayesian approaches. It should be noted that the financial crisis period of 2008-2009 was not included in the analysis and is left for future research.Historical in-sample analysis shows that simple currency betas can explain about half of the currency manager composite index returns, with a high of 83% and a low of 1% for individual managers. The excess return (alpha) above beta strategies is positive and statistically significant for only half of individual managers, but majority of this alpha can be attributed to market timing of simple currency betas. The results show that it is possible to fully replicate total dollar return for a third of the average currency managers using simple currency beta strategies. Among the methods for replicating returns, independent combinations, such as equal weight and Black-Litterman, have a higher chance of replicating target manager returns when compared to tracking replications. The results indicate that it is quite possible to replicate the total returns of diversified portfolios of currency managers, but it is much harder to replicate the returns of individual managers.