With a traditional 60/40 portfolio that comprises 60% stocks and 40% bonds, the weightings between stocks and bonds will be based on a fixed percentage of the dollar value of the portfolio.  That is, the managers will allocate 60% of the portfolio's value in dollars to stocks and 40% to bonds.  Other combinations, such as 30/70, will similarly depend on percentages of the portfolio's dollar value.  Some portfolios that are more diversified may have smaller amounts allocated to a larger number of assets classes, such as 20% each to US stocks, foreign stocks, bonds, REITs and commodities.

The problem with this approach is that different assets have different levels of volatility, and there will be inevitably be an unbalanced allocation since asset volatility has not been taken into account in determining how much to allocate to each asset.  In the 60/40 example, stocks, which are generally much more volatile than bonds, will dominate the portfolio performance.

A more balanced approach is to periodically measure the volatility of the assets in the portfolio and adjust the weightings assigned to each asset based on an estimate of future volatility.  If a manager takes this approach, then so long as the volatility of the assets in the future is similar to the volatility in the past then the assets will be relatively balanced in the portfolio and the portfolio's return will be more representative of the returns of all the constituent investments.

I take a similar approach in sizing the positions in the Global Markets Program portfolios.  When I put on a new position for the portfolio, I measure the historical volatility of the relevant market and use an algorithm to determine the size of that position that calculates a position size inversely related to the market's volatility.  That is, a less volatile market such as a shorter term treasury note futures market will call for a larger position, while a more volatile market such as an emerging market currency futures market will call for a smaller position.  The result should be a relatively well balanced portfolio. 

I am a big believer in using diversification as a tool that I believe can improve the risk adjusted performance of a portfolio.  This concept starts with the proposition that whereas the overall return of a portfolio will equal the sum of the returns of the constituent investments in the portfolio, the volatility of the overall portfolio's returns will be less than the sum of the constituent investments' volatilities if the constituent investments' returns are not perfectly correlated.  If the net return of the constituent investments in a highly diversified portfolio is positive then the volatility should be somewhat dampened and the result should be a smoother ride.

While the traditional 60/40 stock and bond portfolio achieves a level of diversification by including both stocks and bonds together, some commentators, especially Ray Dalio, have made the point that traditional stock and bond portfolios are designed to perform well in environments with low or decreasing inflation.  Harry Browne and Dalio suggest adding gold and other commodities to a stock and bond portfolio to give the portfolio the added ability to perform well in an environment of increasing inflation.

Instead of using just gold or a commodity index to provide this exposure to a portfolio, I aim to achieve a higher level of diversification by adding many individual commodities and currencies.  Thus, individual positions in agriculturals, metals, energies, materials and both developed and emerging market currencies provide my portfolios with exposure to many unique markets driven by their own economic factors. 

​I select my portfolio positions from a universe of more than one hundred separate markets spanning stocks, bonds, currencies, and a range of different physical commodities markets, traded in or representing the economies of many different geographic regions around the world, and typically my portfolios have positions on in three to five dozen markets at any time.  This very high level of diversification should provide the ability for the portfolio to profit in many different unique environments, since combinations of increasing or declining growth and inflation, and other unique economic factors, will be occurring at different rates in different places and have different impacts on different markets.

A number of emerging market currencies have made significant moves lower recently, presenting quantitative macro traders with the question of whether there may be positive expectancy positions to be taken in any of these currencies.  While there are conflicting analyses with regard to some of these currencies, the answer for me currently is that it makes sense to be long the South African rand and short the Russian ruble and the Brazilian Real.

The Chicago Mercantile Exchange has futures contracts with active screen trading in a number of emerging market currencies, including the Indian rupee, the Brazilian real, the Mexican peso (which is highly liquid and some consider now to not be an emerging market currency), the Russian ruble and the South African rand.  I will limit my analysis here to these currencies since they are the most accessible via CME futures contracts.

Historically, a major fundamental driver for currency exchange rate movements has been relative interest rates.  Currencies of countries with relatively high interest rates have frequently tended to appreciate against currencies of countries with relatively low interest rates, as a result of investors generally selling lower yielding assets in the low interest rate countries and buying higher yielding assets in the high interest rate countries.  When this phenomenon occurs, a trader that is long the high interest rate currency and short the low interest rate currency will not only benefit from the directional change in exchange rates but will also earn the "carry" from the difference in the interest rates.  This carry return manifests itself in the difference between forward rates built into the pricing of derivatives the trader uses to implement the position (the futures contracts in the case of the CME products I described above), and is generally economically equivalent to the return the trader would have earned if the trader had borrowed currency in the low interest rate country, converted that currency into the high interest rate currency, and then lent the high interest rate currency at the rate available in the high interest rate country while continuing to owe the lender in the low interest rate currency. 

Thus, for currencies of emerging market countries with typically high interest rates (note that most but not all emerging market countries have relatively high interest rates), the above analysis will indicate that a speculative trader should be long those currencies and short low (or even negative in the current environment) interest rate currencies such as the euro, the Swiss franc and/or the yen.  Each of the CME listed emerging market currencies I described above has interest rates significantly higher than those in the lower interest rate developed market countries, so this interest rate based analysis would indicate a bullish view on all of the emerging market currencies I described with active trading on CME.

​However, another, momentum-based approach such as that that I employ, takes a more comprehensive tack and analyzes the recent total return of the relevant currency.  This total return analysis incorporates not only carry but also directional price movement resulting from the actual recent changes in exchange rates.  If the recent total return of a currency has been negative notwithstanding a significant positive carry, then a quantitative trader may decide that the substantial downward directional price momentum indicates some sort of weakness that the trader should interpret as a precursor to future weakness and thus an indication for the trader to not have a position in or to be short the currency rather than long.

One important benefit to this total return based momentum approach is risk management related.  When a quantitative trader applies a momentum approach properly, it generally enables the trader to close losing positions at points allowing the trader to avoid sustaining larger losses that would require higher future gains to recover from.  In contrast, a trader making decisions based purely on carry may stay with a losing position as long as the carry remains substantially positive, and could in theory sustain larger losses if the high interest rate currency depreciates substantially.

In the current environment, the total return of the South African rand has been relatively strong over the last year, meaning that the combination of carry and exchange rate change has made it a profitable currency to have been long through derivative contracts over that time.  In this case, there has been both positive carry return and positive directional price gains as the South African rand strengthened over the last year against the US dollar.  This recent strong momentum tells me that it may be a good environment to be long the rand, so I currently have a long position in that currency.

However, in the case of the Brazilian real and the Russian ruble, substantial recent price weakness has completely overcome the carry return and resulted in a significant negative total return over the last year.  This weakness is large enough that it tells me the better position may actually be to bet against those currencies, and thus I am currently short the real and ruble.  Because short positions have less profit potential and larger risk (a short position theoretically has unlimited risk), I have sized these short positions significantly smaller than the long rand position.

Regarding the Mexican peso and the Indian rupee, recent total return has been roughly flat as weak price movement has generally offset carry return.  The flaccid recent total returns tell me I want to avoid the peso and rupee for now, so I am flat those markets.

Note that I am a big believer in portfolio diversification, and so these three emerging market currency positions that I currently maintain represent a small portion of my overall portfolio of positions.  Each of these positions has points where I will exit the position if it moves sufficiently adversely (generating losses) or profitably (generating profits).  And I have sized the positions in a manner to attempt to balance the risk against the other positions in the portfolio.

Finally, while I believe each of these positions has a positive expectation, it is also important to note that these positions have a significant risk of loss.  I am not advocating others to take these positions, and in fact will state that trading in futures generally and emerging market currencies specifically is not appropriate for all investors.  Instead, I aim for this analysis helps one understand my decision making processes as I go about constructing my portfolios. 
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