Saxo Bank’s TradingFloor.com has released a new FX portfolio model that offers a way to reduce total portfolio volatility in the wake of the stock market rally that saw many investors turn away from forex trading.
“Many investors are staying out of the forex market – either because they lost money and have given up, or because they simply don’t know where to put their money,” says David Karsbl, chief economist and member of the Saxo strategy team that created the model for the strategy and commentary website.
“The Saxo Bank Forex Portfolio Model is a way of re-activating this idle money by applying them in a low-cost and relatively low risk fashion,” he says.
The portfolio model is based on the Saxo Bank Fundamental Indices that measure the underlying economic strength – contraction or expansion – of 10 currencies: NZD, AUD, CAD, JPY, EUR, GBP, USD, CHF, SEK, and NOK. This should give a theoretical 45 possible currency crosses, but the model subtracts the 12 most illiquid and expensive to trade and looks at 33.
The allocation signals are generated by the spreads in the fundamental indices. The idea is to always allocate more capital to the currencies with a relatively strong economic activity or positive rate outlook and fund the positions by going short on the currencies with weak economic activity or rate outlook.
The model allocates capital after changes in the spreads between the fundamental indices. For instance, if the Eurozone Fundamental Index suddenly drops relative to the US Fundamental Index, the model – everything else being equal – would reduce exposure to EURUSD. Additionally, positions are scaled up or down according to the volatility of the currency crosses in question so that the expected risk-adjusted return for positions in EURCHF, for example, is the same as for positions in EURCAD.
“The model is always well diversified and is always in the market,” says Karsbl. “It is therefore not exposed to timing issues.”
The model doesn’t use stops, since the overall volatility of returns tends to be low, particularly on single leverage. Returns tend to be almost completely uncorrelated to returns in stock and other risky asset classes, Saxo Bank says. In back testing since 1991, the model has produced annual returns of 5.34% using single leverage, 10.58% using double leverage and 15.67% with triple leverage.
“If the back-testing is indicative of future returns, it would make a lot of sense to use part of one’s portfolio to allocate to the FX Model and thereby decrease overall portfolio volatility without lowering returns too much or at all, depending on the leverage used,” Karsbl adds.
The model can be used on any platform. The weights in the total FX allocation can be downloaded on the TradingFloor.com site every month after the model has been updated.