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Hedge Fund Monthly
 
Currencies can be a Distinct Source of Alpha
Dr Joe Zhou, James Shang and Christina Mu, Ortus Capital Management August 2006
 

‘Global Macro’ as a hedge fund category can encompass a wide range of strategies and underlying assets. We focus on the major currencies. In this article, we discuss:

  • The current state of the forex market
  • Currencies as a distinct source of alpha
  • Our investment philosophy and investment process

The current state of the forex market

Despite its enormous size, the market for major currencies is relatively young. The final breakdown of the Bretton Woods system in 1973 marked the end of the fixed exchange rate system and ushered in a new era of foreign exchange (forex) trading. After the forced exit of the British Pound from the European Exchange Rate Mechanism in 1992, the forex market basically took on the shape it is today. Nowadays, major central banks target the short-term interest rate as the primary monetary policy tool.

In recent months, the main drivers of major currencies have been a mix of shifting interest rate expectations, the politics surrounding the US current account deficit, the shifts in risk appetite and the buoyant yet volatile commodity markets.

The European Central Bank (ECB) is seen stepping up the pace of tightening and the Bank of Japan (BOJ) is seen entering the tightening mode. The market has spent much of this year anticipating the end of the tightening cycle of US Federal Reserve (Fed), only to be frustrated by the continued rate hikes in the face of increased inflation pressures. The economic data from Europe and Japan have been substantially stronger than expected, prompting expectations that the ECB and BOJ will still be tightening well beyond the Fed.

The Euro has responded positively, but the initial response of the Yen has been somewhat restrained by the belief that even with some tightening, the Japanese interest rate will remain extremely low. The recent appointment of Hank Paulson as US Treasury Secretary and the incipient US inflation problem could undermine any prospect of the US ‘engineering’ of a weaker US dollar in the near term. The equity markets suffered in May and June with unusually high volatility, so did the commodities.

The rise in risk aversion is dissipating lately, although poor US inflation numbers and an extended Fed tightening beyond a 5.5% fund rate can quickly take its toll. In the months ahead, the likely focus will remain on the asynchronous G3 interest rate cycles.

Currencies as a distinct source of alpha

An exchange rate is a reflection of the relative strengths and the relative tightness of monetary policies of two countries. The sources of currency returns by nature are different from equities or bonds. A well-constructed currency portfolio tends to have a low correlation with equity or bond markets. It also tends to have a low correlation with other hedge fund strategies, such as equity long/short. A well-managed currency programme can be a distinct source of alpha. Ortus Fund’s correlation with major asset classes since its inception in September 2003 has been low.

In addition to the desired low correlation feature, a well-managed currency programme can also offer an attractive risk-reward profile on an absolute basis. From September 2003 to July 2006, Ortus Fund has delivered an annual compounded net return of 17.23% with a volatility of 11.85% and a Sharpe ratio (net) of 1.23. We believe that with time, our strategy is capable of delivering close to a 20% net return with similar volatility, since the ‘driving forces’ for returns in the forex market (to be elaborated below) have remained for decades and we expect this to continue into the foreseeable future.

Our investment philosophy and investment process

The forex market is truly ‘macro’. A myriad of participants trade in the market. By the law of large numbers, idiosyncrasies on the micro level tend to smooth out. This makes rigorous mathematical modelling a powerful tool in characterising the interactive and dynamic relationships among forex market, other financial markets, monetary policies and underlying economic fundamentals.

When economies and their corresponding monetary policies fluctuate over time, exchange rates tend to go through cycles. A typical cycle can last a few years and the peak-to-trough swing can exceed 60%. In our view, the cycles in exchange rates are generated by dynamic interactions between asset prices and underlying economic fundamentals. Differences in countries’ economic fundamentals, coupled with a lack of full global participation (eg. home investment bias), can give rise to differential asset returns in different countries. Differential capital productivity induces capital movements, and capital movements will in turn affect economic fundamentals and capital productivity. Many factors are involved in the interactions such as shifting interest rate expectations, inflation expectations, risk appetite and economic fundamentals. Our edge lies in our ability to systematically quantify these interactions.

Our models are based on innovative applications of dynamic equilibrium theory and are calibrated against current market conditions. Our market views are expressed effectively as a ‘joint probability distribution’ of future currency returns. Expected and covariance matrix of currency returns are estimated by our models as the dynamics unfolds over time.

At any given time, the optimal portfolio is computed by disciplined portfolio optimisation and risk management programmes. When the new optimal portfolio is sufficiently different from the existing one, the differences are traded. This is a continuous and dynamic investment process. Portfolio weights are determined by mean-variance optimisation (subject to well-defined positional constraints), and portfolio size is computed to optimise long-term portfolio performance using our optimal drawdown control programme. This programme is based on the award-winning paper, “Optimal Investment Strategies for Controlling Drawdowns”, Mathematical Finance (July 1993). It can skew the return distribution towards the high-return side with downside controlled. The resulting portfolio has been well behaved with modest volatility and leverage, and has low correlation with major asset classes.

The portfolio approach empowers us to exploit opportunities in all currency pairs, not just currencies against the US dollar. Clearly, it generates higher alpha than alternative strategies such as simple long or short of a currency against the US dollar. It also reduces the exposure to idiosyncratic risks. Although there are a relatively small number of major currencies to trade, a portfolio of major currencies can achieve excellent diversification, because much diversification already happens before reaching the macro level.

By staying with a trend with conviction, predicting trend reversals with confidence, and exploiting micro trends with finesse, our quantitative investment programme offers a distinct source of alpha and a source of high-quality absolute returns.

 

If you have any comments about or contributions to make to this newsletter, please email advisor@eurekahedge.com

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