If asset classes were racehorses in the quant strategy stakes, foreign exchange’s odds would be shortening fast.

Banks are reporting heavy backing for FX-flavoured quantitative investment strategy (QIS) trades, prompting them to expand their activities in the asset class.

JP Morgan reports double-digit growth in client investment in FX strategies, outpacing the wider QIS business.

UBS says client requests for such trades have “increased significantly” in the last 18 months.

“It’s a shining moment for FX strategies,” says Pablo Suarez, managing director for QIS at BBVA. The Spanish bank recently added foreign exchange to its QIS business, launching a set of 60 systematic indexes across G10 and emerging market currencies, including Latin America.

Other banks are looking to ramp up their FX offerings, in anticipation of greater client inflows. “What has changed is the scale of the business,” says Xavier Folleas, global head of QIS structuring at BNP Paribas. “We see more and more interest from clients in [FX] QIS”.

Once a lagging asset class in the QIS toolbox with lacklustre returns, some risk premia in foreign exchange are now delivering outsize profits. Data from QIS analytics provider Premialab shows FX global carry returned 6.52% in the 12 months to the end of March – not spectacular, perhaps, but good enough to make the factor a top 10 performer among a set of 37 pure risk factor benchmarks published by the firm.

The outlook for the asset class has changed for a mix of reasons, some fundamental, some more technical.

Carry differentials are growing, which is helping to strengthen the case for FX risk premia, says Geoffroy Samarcq, a strategic index structuring head at JP Morgan. The carry trade is a common way of exploiting differences in interest rates between countries. In the years prior to Covid, compressed yields and moribund volatility left slim pickings for FX investors.

Central banks are also diverging in their monetary policy stance after years of ultra-low rates and monetary easing across the board. These disparities will introduce new wrinkles between currency markets that investors can exploit, experts say.

Another factor is the rise of multi-asset portfolios, which use FX quant strategies to diversify their exposure. “A large part of this demand came from cross-asset portfolios and solutions, because FX QIS is able to bring alternative sources of return and diversification versus risk premia for traditional asset classes,” says Ben Laloum, head of rates, FX and credit indices structuring at UBS.

While dealers see growing demand for the most commonly traded linear strategies, such as carry, trend and value, increased interest in the asset class is seeing many teams push into new territory with more complex data-intensive strategies.

Sean Flanagan, global head of QIS at Deutsche Bank, highlights topics such as intraday dynamics, liquidity pockets, overnight-versus-intraday moves in currencies and the use of currency pairs to replicate commodity exposure as promising for investors.

A lower handicap

QIS, which use mathematical modelling to extract risk premia for diversified sources of return, began life in equities and commodities, where the prevalence of listed products ensured ample data for building systematic strategies. The trend quickly expanded into over-the-counter markets such as FX, where banks began building alternative risk premia strategies such as carry, trend and value, using OTC instruments such as forwards and non-deliverable forwards.

While systematic indexes offering FX risk premia have been around since 2016, the asset class underwhelmed during the ultra-low-rate environment. This is changing amid macro uncertainty and diverging monetary policy.

“Volatile inflation paths and central bank actions” are leading to expectations of “large FX spot moves”, says Laloum at UBS.

While central banks in the US, UK and eurozone are expected to cut rates this year, lingering inflation has muddied the picture on magnitude and timing. Meanwhile, Japan’s central bank is embarking on normalisation path, hiking its policy rate to 0.1% in April to end eight years of negative short-term rates.

Siddharth Grover, managing director for QIS at BBVA, says FX is often the most appropriate asset class to trade these disparities across economies.

“The main thing about FX – and it has been argued in most of the research – is that it is the easiest way to play divergence in economies. Typically, emerging market equities and bonds at various periods can be relatively less liquid, whereas FX markets have high liquidity,” says Grover.

He adds that a “changing macro environment has increased the demand for FX risk premia such as trend and value, which are much less correlated to traditional assets.”

Carrying weight

As a top performer, carry strategies have attracted the lion’s share of inflows. The trades see investors borrow in low yielding currencies – such as Japanese yen – and invest the proceeds in a higher yielding currency or basket.

Societe Generale recently expanded a popular equity volatility carry strategy, known as Step, to foreign exchange.

Originally created as a relative value play on S&P 500 options, the strategy monetises a risk premium embedded in short-term out-of-the-money put options by systematically selling the instruments. The dealer has expanded the strategy to four currency pairs: euro/sterling, US dollar/sterling, euro/yen and US dollar/yen.

The FX version of the strategy is typically more directional than its equity carry counterpart, according to Guillaume Arnaud, SG’s global head of QIS. He says the strategy can be subject to idiosyncratic risk such as monetary policy changes on specific pairs.

“If we want to be successful, we need to diversify across more pairs to limit pin risk linked to a specific pair. You probably want to diversify this a bit to make it more absolute return and less subject to a specific idiosyncratic risk that would materialise.”

Pin risk occurs when the price of the underlying asset or currency pair hovers near the strike price at option expiry, making it hard for dealers to hedge any last-minute moves in the market.

BBVA is thinking along similar lines with a more dynamic approach to carry strategies, where the cost of entry has risen in recent months.

“It has worked quite well to be static in borrowing in Japanese yen for most of my career, but things could be changing so we have a dynamic strategy, which allows us to choose the best possible pairs for clients,” says Grover.

Returns have been less compelling for other FX risk premia. Data from PremiaLab show FX global trend delivered negative returns of -3.24% in the 12 months to the end of March. Trend uses macro signals to take a position in an asset on the assumption a particular scenario – such as rising inflation – will continue.

Patchy performance across individual factors is a driver behind BBVA’s decision to launch a range of FX strategies, rather than rolling out individual indexes on a piecemeal basis. The bank’s offering comprises strategies relating to carry, trend and relative value.

“A portfolio of the three offers clients a way to hedge the risk they want to hedge or take the risks they want to take, so we’re launching it as a portfolio rather than just offering one or two of them,” says Grover.

Relative value sees investors take exposure to an asset in response to a market shift, assuming the prices will eventually revert to their long-term average.

UBS notes that it has had success in a mean reversion strategy relating to G10 currencies, with the strategy posting four years of positive performance.

Study the form

In addition to macro drivers, dealers say improved access to transparent data has been pivotal in extending strategies commonly seen in liquid G10 currencies to emerging markets.

Improved macro data within emerging market economies and countries has allowed QIS teams to construct more indexes in the emerging markets space. Bankers note that liquidity has also improved in some emerging markets, greasing the QIS wheels.

Emerging market FX risk premia can be used for synthetic replication, Laloum says. Synthetic replication involves mirroring an index or benchmark by creating a replica using derivatives.

“This is an area where we are spending some time on as well: the replication and enhancement of benchmarks and using emerging market FX as a way to diversify those benchmarks,” Laloum says.

Flanagan at Deutsche Bank explains that emerging market currency exposure can be a useful tool for replicating emerging market bond performance “which can either be used as an asset replacement or used as a very liquid hedging tool for emerging market bond exposure within client portfolio”.