What should be the Benchmark Rate of Return for FX Traders and Investors?

It’s a tough question to answer, but a Quora user posed an important question that will be answered.  The Benchmark Rate of Return helps set expectations for investors, traders and portfolio managers.  The problem that is far too frequent is that the information to make this gauge is either limited or tough to find.  Sample size matters and even in the realm of currency investments (FX or Forex), the jury is still out on the topic.  What nobody wants is a market environment that is free of benchmarks or is populated by benchmarks that are derived from unreliable, anecdotal sources.  Benchmark figures are used in all industries for different disciplines from Marketing to Medicine, what makes Forex an unusual exception?

First, let’s just verify to you, the reader and hopefully a subscriber/client of the future that this is indeed a Quora question.

In portfolio management, the Benchmark Rate of Return is often called the “required rate of return”.  The required rate of return is often considered a minimum benchmark rate of return.  This means there’s a range of possibilities?  To an extent, yes, because market environments are different on a monthly, quarterly and annual basis.  Performance benchmarks often end up with a mean return per timeframe and the periodic basis desired.  This naturally means that one can create a benchmark range that is within one standard deviation of the mean.  With this sort of a standard, the minimum benchmark rate of return would be one standard deviation below the mean.  Problem solved and that answers the question, right?

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What about the data supporting the Benchmark Rate of Return?

The Benchmark Rate of Return from a more theoretical perspective is easier to determine in the equity markets.  If one chooses to define a market index (S&P 500) as the mean benchmark and then use the market index’s standard deviation above the mean as the required return, it would be quite reasonable.  The data is very accessible and it can be broken down on many different levels, the work has been done already to establish that as a standard should that be the desired standard.

Moreover, for those benchmarking on the equity markets, it is easy to draw comparisons between funds and gauge how a particular company’s stock performs against the overall market.  There’s simply greater transparency outside of the hedge funds that publicly release their periodic returns.

However, in the currency market, it does not work this way.  Comparing a fund or even individual trading efforts against a Euro, U.S. Dollar, Canadian Dollar, Japanese Yen or whatever currency index just does not make much sense.  It’s not really a comparison against the market, it is a comparison against how a particular currency performs against a weighted average of currencies.  None of the indices represents an actual market environment.  For each currency pair, if one currency strengthens, the other weakens.  It’s not like this for the equities market.

The data is a bit tougher to come by and it is in this case that even the CFA Institute acknowledges this problem.  It requires stepping back and re-thinking how benchmarks are set.  However, the given circumstances should not excuse a lack of a market benchmark in key performance management and risk metrics in a portfolio (even if the portfolio is a single holding).  This is the status quo that upholds a paradigm where the majority of retail FX traders losing money and many participants being scammed.

How is this fixed?  What can be considered a Benchmark Rate of Return in the FX Market?

There are four ways to approach this.

Solution #1:  Use the equity markets.

The FX Market serves as an alternative of the equity markets.  Instead of investments and trades being made in the equity markets, the money is going into the Forex Market.  Now, the rationale is based on the idea that many of the retail Forex participants are eschewing the returns of the vastly de-leveraged equities market for the highly-leveraged Forex Market.  Instead of funds going into Netflix (NFLX) or Goldman Sachs (GS) stock, those funds are going to be used for trading EUR/USD, AUD/JPY and other currency pairs with the hopes of generating a higher return with less funds.

This puts the two markets in competition with each other, but they are not.  The FX Market is substantially larger and it is buoyed by institutional traders.  There are traders for each type of market on the institutional level.  They do not have the scarcity of resources like the way an average retail FX trader would.

To address the benchmark issue on a particular time frame and periodicity, simply take a global weighted average by market cap of the returns generated by the S&P 500, S&P/TSX 60, CAC 40, FTSE 100, DAX 30, Nikkei 225, Hang Seng Index, S&P/ASX 200, NZX 50, and Swiss Market Index.

Solution #2:  Use the currency mutual funds.

In this case, the currency mutual funds that exist are averaged (arithmetic mean and/or weighted average – both would be suitable).  If there is a currency mutual fund offered include it in the average and use that averaged return and standard deviation to form your benchmark rate of return range.

Solution #3:  Weighted average of interest rates.

Each Central Bank offers an interest rate and traders are able to collect on the interest or pay the interest at the end of every trading day.  When traders/investors hold a position for the purpose of making a return on the difference between interest rates, they are called carry traders.  An example of a carry trade pair that would generate a higher rate of return would be MXN/JPY, which would be the Mexican Peso against the Japanese Yen.  Selling the Japanese Yen and buying Mexican Pesos.  The Bank of Japan has an interest rate of -0.1%, which means that to sell the Japanese Yen, you will receive a return as opposed to paying the interest rate.  Banco de Mexico offers a 7.5% interest rate, which means that after a year, investors who hold an MXN/JPY position will receive .1% from the Bank of Japan and 7.5% on their investment from Banco de Mexico.  For a $100,000 USD volume position (a standard lot), a trader can receive $7,600 USD on their investment in interest.  The risk is a margin call due to the currency pair price movements.

Taking the interest rates of the eight major central banks (Federal Reserve, ECB, Bank of England, Bank of Canada, Swiss National Bank, Bank of Japan, Reserve Bank of Australia, Reserve Bank of New Zealand) and averaging them on a weighted and leveraged basis (your own leverage) can be a benchmark.

Solution #4:  Average of Forex Signals (Copy Trading) Providers and PAMMs

Taking an average of returns from Forex Signals and PAMMs would provide a reasonable leveraged benchmark rate of return.  In fact, this would most closely mimic the expectations a retail Forex Trader should have considering that these traders are leveraged in the same market as them!

The Answer to the Quora User’s Question

It really depends, but using these four approaches and then making an acceptable range is a good idea.  Of course, every trader and investor has different needs and levels of risk-aversion.  It’s good information, but the risk metrics are important as well.  It really depends upon the investor’s goals, investment level, and how the investor is planning to approach the market.  More than likely, these benchmarks will not matter since approximately 70% of retail Forex traders are unprofitable at any given quarter and the biggest culprits are addressed here.