Diversifying forex portfolios: A strategic guide for forex fund managers and traders

The Banks for International Settlement, through their survey in 2022, revealed that daily Forex trade resorts to a turnover of $7.5 trillion, giving it dominance in the world of digital trades and asset liquidation. The financial market of forex is large; having traders sell and buy digital assets globally, almost simultaneously, only shows the potential of forex to its traders. Foreign exchange (Forex) is characterised by high levels of risk ranging from price fluctuations to the volatility of currency pairs, which poses great challenges for traders and fund managers; the significance of risk management in this case becomes crucial.

Fund managers and forex traders must seek ways to diversify their investments in order to escape hitting rock bottom and levelling down with extreme loss. This diversification hangs on the spreading of investment across multiple assets to not only optimise returns but serve as a way to mitigate the harsh waves of the market. This article is therefore set to explore diversification strategies in forex trading, its importance on portfolio performance, and practical insights needed to solve underlying issues faced by traders through theoretical case studies and statistical analysis.

Literally, the word ‘diversification’ means a process of setting in range or expanding in variety. This definition is synonymous with its function in digital trading as it is in forex, where diversification is simply an act of investing in different digital assets to reduce risk. This process is the chief cornerstone for modern forex trading, as it stands as one of the most beneficial strategies in forex, applying to currency pairs, trading techniques, and the tailing of investment horizons. It helps to manage unexpected market outcomes amid economic and geopolitical factors affecting currency pairs. Forex diversification differs from fixed-income portfolio diversification, which basically allows for assets to be allocated to various sectors or grouped in various classes, which is still subject to high risk. Some of the types of forex diversification include:

Currency pair diversification

Currency pairs, which combine two currencies, are used in forex trading to trade at profitable exchange rates. Diversification allows traders to invest in major, minor, and exotic pairs, such as EUR/USD, GBP/USD, and USD/JPY. A hypothetical forex portfolio with multiple currencies performed better than a non-diversified portfolio, which was affected by market volatility. The portfolio with diversification also performed at a 1.2 ratio, protecting returns from risk against erratic currency movements, especially during political uncertainty in the Eurozone.

It’s safe to say that with currency pair diversification, risks are effectively managed and returns are evenly adjusted. This, however, is dependent on the choice of currency forming the portfolio; fund managers should ensure that the currencies correlate such that the weakness of a combo can lean on the strength of another.

Temporal diversification

The Forex market is open on a 24/7 basis, and this is applicable for different countries and continents based on their time zones, further projecting that levels of market liquidity and volatility differ. This mode of operation can be used to an advantage. Fund managers and traders can seize this opportunity to diversify trades during the peak trading hours of some countries, meaning that time zones must be studied alongside the trade patterns of these countries in order to fully harness the opportunities that the market presents and capitalise on the unique conditions of the market.

Temporal diversification involves traders adopting different time zones to approach market trends based on trade patterns. This strategy has proven effective in portfolios with diverse trades across Asia, Europe, and North America, resulting in a 15 percent cumulative return in three months compared to a 10 percent return for a solely European-focused portfolio. The diversified portfolio had more market balance and a 5 percent lowered maximum drawdown, contradicting the non-diversified portfolio’s 5 percent drawdown.

Temporal diversification is worthy and a sure strategy that fund managers ought to utilise in order to gain from different market conditions across trading sessions, enhancing returns and reducing risk.

Strategy diversification

This type of diversification follows the deployment of different strategies used to have an edge on different market trends. These strategies are expected to have flexible usage, such that it’s utilised in a mixed form to reduce the risk of underperformance; should a certain strategy fail, the other could live up to expectations. Some of these strategies include following trends, mean reversion, and carry trading.

For trend following, here, fund managers are expected to follow the direction of already established market trends after study. This particular strategy demands concentration and patience because a little distraction could amount to a huge loss. This strategy has been tested and approved by forex trade experts to generate significant returns when a strong market trend is followed meticulously.

Mean Reversion, on the other hand, is the strategy based on the assumption that currencies and their prices, after several market fluctuations, would eventually return to their historical averages. While this strategy has proven to perform significant returns in range-bound markets, it would struggle during waves of strong market trends.

Carry trading is the strategy that operates on borrowing currencies with very low interest rates in order to invest in currencies that have a higher interest rate. It basically carries from the weak to the strong, providing steady returns of investment and easy market transition, but in the long run, when the market becomes volatile, it becomes sensitive to interest rates, causing wide price differences and market risk sentiments.

Dudely (2012), in his research, discovered that a certain portfolio was built with the aforementioned strategies, and the performance during a market pitch was impressive. This diversified strategy was able to ensure a stable return of 20 percent and a 15 percent Sharpe ratio over six months as compared to a singular trend-following strategy with a 12 percent return and a Sharpe ratio of 0.9. The data of this research suggests that while the mean reversion strategy provided enormous profit during range-bound markets, carry trading helped when the market had a low volatility rate.

Strategy diversification is a beneficial mode of forex diversification, as it’s proven to enhance portfolios’ performances by ensuring steady returns, reducing the reliance of a single market trend.

Forex diversification is beneficial for managing risk during trading, but it has limitations such as over-diversification, correlation risk, and complexity. Over-diversification can lead to burnout and a tendency to gain in a few and lose in many. Additionally, correlation risk occurs when currency pairs become in tandem during market surges, reducing the effectiveness of diversification. Complexity and costs also affect traders’ diversification, making it tedious to manage due to sophisticated analysis, time-consuming monitoring, and increased transaction costs due to market proliferation.

Fund managers should pause when they should and plan according to the waves of the market. Diversification should be done when there’s enough to spare, excluding your fixed savings.

Conclusion:

In foreign exchange (Forex), diversification remains a useful tool for controlling risks and advancing the returns of investment. A judicious and meticulous hop on strategy diversification, temporal diversification, and currency pair diversification can lead to building strong portfolios that would show resilience in the face of market volatility. These diversification modes could shine in different market opportunities; so far, they’ve been designed with a consistent flow of understanding, monitoring, and an interplay of other market factors.