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Has it Become Harder to Find Alpha in FX?

It’s not necessarily that extracting alpha in FX has become harder, but rather that the way it needs to be extracted is changing, said panellists at Profit & Loss’ Forex Network Chicago conference.

Douglas Cilento, global head of execution at AQR, opened the discussion by point out that FX has traditionally been viewed as a good market for generating alpha because there is a large segment of non-profit seeking market participants, there are inefficiencies in the market and, because currency is not something that can be bought and held with the expectation of a return, it is effectively a market without beta.

Despite this he noted that “generating alpha on a consistent basis has always been hard in FX”, and that this will continue to be the case. Cilento did add that the difficulty in generating alpha depends on the strategies being deployed and the perceived edge, time horizon trading within which they are used, commenting that the current market environment is probably more challenging for short-term alpha strategies given the lack of liquidity and increased operating costs.

Other panellists noted that the alpha generating opportunities for firms trading FX have shifted, with Ralf Donner, executive director, algo strategy, at Goldman Sachs, identifying some clear changes that have taken place in this regard post-financial crisis.

“Pre-crisis was the world of the G10 carry trade, and that is now mostly dead. But it has been replaced by other opportunities. For example, there are volatility trades that are very interesting because there is an implied versus realised volatility bias that used not to exist, which has been created because of factors such as central bank interventions,” he said.

Donner continued: “So I think the opportunity set has simply moved, with risk on, risk off, being another interesting area where things have changed since the financial crisis. I’ve been looking at correlations between different FX markets and it’s interesting to note that pre-crisis a high correlation environment typically meant a risk off environment and now it’s no longer so clear, you can have a high correlation environment and it’s low volatility at the same time.”

Raising the bar

Likewise, Giovanni Pillitteri, global head of foreign exchange trading at GTS Securities, noted a distinct shift in alpha generating opportunities. He pointed out that while some alternative asset managers have had difficulty producing alpha in FX in recent years, the firms that have deployed more systematic strategies have been very successful in this asset class.

Specifically, Pillitteri highlighted that these strategies have been particularly effective during event driven moves such as the volatile trading environment that followed the Brexit vote.

“Scouting for alpha is always challenging, but the opportunities are shifting towards more binary event driven types of strategies and this development is probably a reflection of the electronification of pricing and new technology, which has raised the bar for everybody. Having alpha has dramatically increased our effectiveness in becoming a leading market maker,” he said.

When questioned on whether the nature of alpha generation has changed from picking directional moves based on fundamentals to taking fractional amounts across a large number of trades, Pillitteri noted that “market makers’ margins are getting compressed because of increased competition and therefore, firms need be more holistic, systematic and data driven in their approach.”

Expanding upon the idea of finding new approaches to trading Cilento observed that, with traditional carry trade strategies struggling in the current low interest rate environment, more firms are attempting to combine a variety of different quantitative strategies.

“One thing that some funds are doing right now is combining a lot of these factors, so they’re building strategies that pair momentum with carry and value to take advantage of the diversification benefit. I think that’s what a number of quant funds are looking at right now, and I feel like there’s a lot of opportunity there,” he said.

He also said that while short-terms strategies repeatedly taking small profits is one form of alpha, there is still alpha available for longer term strategies. Cilento pointed out that while some fund managers using longer-term strategies have struggled, if alpha is truly a zero-sum game then that means there are other fund managers doing very well.

“It’s all about your time horizon. If you have an extremely short window then I think the markets have become a little more difficult because the market structure has changed. Measures have been put in place to slow down HFTs with a clear speed advantage, it’s an arms race and firms need to justify the cost of technology and if it’s not as easy to capture that small spread over and over again you’re going to see that in their liquidity offering and also in their profits. 

“I think the market makers relying on speed and connectivity to generate alpha need to start looking further out and really examine what their alpha decay horizon and ultimately align their trading strategies to that,” he said.

Optimising alpha opportunities

With alpha opportunities seemingly more scarce in FX due to a lack of interest rate differentials and dampened volatility, the panellists said that platforms can play an increasingly important role in extracting alpha from their trading.

For example, John Miesner, managing director, global head of sales at GTX, emphasised how platform providers can provide trading firms with tools to help them optimise their alpha generating opportunities.

“From our perspective, we are trying to enable our clients to generate alpha and therefore we continually work to provide them with analytics that will give them a bespoke perspective of the market.

“When clients look at the opportunities in our marketplace, they are looking at it from their specific viewpoint. What we do with clients is give them data and analytics that can show them opportunities to make money they may not have seen otherwise. It might be that there’s liquidity available where ordinarily a particular firm might not be looking.

“On top of that, there’s the operational side, where we look to provide firms with the best liquidity under the most difficult of circumstances. Additionally, we offer them a look across multiple currency pairs that they would not ordinarily be trading. This “look” provides them with new areas of opportunities,” he said.

Also talking from an ECN perspective Dmitri Galinov, CEO of FastMatch, said that platforms can help alpha seeking firms by focusing on helping them trade effectively in FX’s fragmented market structure and enabling them to reduce their implementation shortfall.

“As the market has become more complicated and dispersed it has become more difficult for our clients to figure out the market structure and determine how best to buy or sell currency without moving the market too much.

“It’s definitely a more complex market than it used to be but there are technology solutions that I think, combined with an understanding of the FX market microstructure, will save these firms money and that will contribute to their alpha generation,” he said.

Galinov later added: “When markets are slower, that’s when people look at cost cutting measures to figure out how they can drive alpha, and we see clients that generate alpha increasingly scrutinising how they execute. When there is low volatility and there’s not as many trading opportunities people look to optimise their operations, they want to figure out how they can trade smarter and get more juice from their execution.”

These comments were echoed by Donner, who stated: “The big story for me over the past couple of years has been the increased interest by hedge funds in pre-trade and intra-trade transaction cost analysis. A simple problem in FX is understanding volumes, even trying to assess what is available in the market or looking at an order book picture of the market and trying to asses how much of the liquidity you can you aggress against and how much of it is firm versus non-firm, etc, can be challenging.

“These are difficult questions and banks are in a good position to provide input on them because they have this experience in market making. But it’s been fascinating to observe that portfolio managers at funds are taking an active interest in what their execution guys are doing and getting very savvy about how to execute in FX.”

Galen Stops

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