Foreign exchange hedge funds often do well when stocks don’t. But that’s not their only appeal.
By Eric Uhlfelder
October 2001
Institutional Investor Magazine
Many hedge funds provide a way to invest in declining markets. But one type has fared well in both difficult and rising markets. Commodity-trading-adviser-directed accounts, which invest long and short in agriculture, currencies, energy, financial indexes, interest rates and metals, have achieved annualized gains of 5.54 percent over the past two years through July, according to International Traders Research of La Jolla, California. The Standard & Poor’s 500 index return for the same period: -4.6 percent.
An intriguing subset of CTA funds are those that deal exclusively in foreign exchange. ITR reports that currency funds have been up every year since 1996, returning an average of 11.81 percent annually. Although their recent performance has slowed - up an annualized 4.88 percent over the past two years through July - the funds have still trumped the Dow Jones industrial average, Nasdaq composite index and S&P 500. This year they were modestly ahead as of July, in contrast to an 8.3 percent slide for the S&P 500.
Moreover, currency funds have achieved these gains with an average monthly standard deviation of 3.87 percent since January 1996, indicating significantly less volatility than either the S&P 500 (4.71 percent) or the average CTA fund (4.68 percent).
But what makes currency funds so attractive at a time like this is their ability to exploit market volatility. The world’s largest financial market, with more than $1.1 trillion in trades executed daily around the globe, the forex market offers superb liquidity. But it also offers continuous buying and selling opportunities. “Exchange rates, even between two industrialized countries with healthy economies, can move against each other by 10 or 20 percent in a year - and they can move right back again within a few weeks,” points out foreign exchange adviser Rudi Weisweiller, author of Managing a Foreign Exchange Department.
However, the essential reason that currency trading can be so consistently profitable lies in the nature of most forex transactions. “Approximately 80 percent of all currency contracts are for defensive purposes, to hedge the risk of foreign investments,” observes Gary Klopfenstein, president of GK Capital Management and chief investment officer of Banc One Currency Advisors. When multinationals, banks or insurance companies enter into a contract to buy or sell a currency at a future date, they are chiefly looking to lock in the value of a future revenue stream or payment obligation, not make a profit on foreign exchange. “Therefore,” says Klopfenstein, “with the bulk of trades ignoring whether a currency is undervalued or overvalued, foreign exchange traders often have the opportunity to profit from subsequent currency corrections.”
Another strong selling point for currency funds, says ITR operations director George Shinn, is that they are almost completely uncorrelated with major stock indexes. So they offer shelter in times of market upheaval, such as during the 1991 Gulf War or the 1998 Russian debt crisis. In the Russian episode, for instance, the average currency fund was up fractionally, while the Dow Jones industrial average tumbled by more than 15 percent.
Currency trading programs can provide greater predictability than other CTA-style investments because they tend to be highly disciplined. Most traders, in fact, follow a rigorously systematic approach. Mark Rzepczynski, senior vice president of research and trading at John W. Henry & Co., one of the U.S.'s leading CTAs, adheres to lessons learned from past market behavior. “News is forever the great uncertainty,” he says. “But we have found that human/market responses to specific types of events generate predictable trading patterns, on which our proprietary trading programs are based.” Rzepczynski’s G-7 Currency Fund was up 3.5 percent this year through July and has enjoyed average annualized returns of 10.89 percent since January 1996. But these results have come with a volatile standard deviation of 5 percent.
Other traders appear to rely as much on honed instincts as on systems. As Kenneth Jakubzak, principal of KMJ Capital Management’s currency program, notes, “Use of market triggers coupled with discretionary response to changing macroeconomic and political trends have often proved to be an accurate means of gauging future currency movements.”
Jakubzak contends that following instincts grounded in experience allows him to react effectively to conflicting developments. For instance, the release in late summer of promising U.S. data on manufacturing output, hinting at an economic revival, was promptly followed by worse-than-expected unemployment figures, compounding uncertainty. Instead of zigging and zagging with each development, Jakubzak says, he exercised his discretionary authority to cling to the sidelines. In early September his fund was primarily in Treasuries. For the year through July, KMJ’s Currency Fund was up 5.3 percent, and since the start of 1996, the fund has racked up annualized gains of 15.37 percent with moderate volatility of 4.11 percent.
To bet for or against one currency relative to another, traders typically use forwards: customizable, $1 million-plus, two-party contracts that can last from days to more than a year. Currency fund managers shorted the euro when it appeared to receive little support after its January 1999 inception by purchasing forward dollar contracts. They were therefore able to profit from the momentum of the euro’s nearly 30 percent decline against the greenback during the European currency’s first 22 months of trading. Then late last year and into early 2001, traders profited from the euro’s 13 percent rebound, brought about by central bank intervention and a weakening U.S. economy that established a floor under the currency.
This is not to suggest that traders are right all - or even most - of the time. The majority are trend followers, so they tend to be hurt whenever a currency reverses course. When the euro finally rebounded late last year, most analysts assumed the currency was headed toward parity with the dollar. But the euro subsequently retraced its steps almost all the way back to its historic lows.
Currency funds rely on two basic techniques to manage risks. The first is the use of fairly quick stop losses. Because currency funds mark to market every day, they could easily be off 10 to 20 percent on paper if they tried to wait out a temporary downturn. Says Klopfenstein, “In the foreign exchange business, hanging on like this would likely affect our competitiveness, so we cut our losses short and let our profits run to ensure a strong profit-to-loss ratio.”
Currency funds’ second major means of loss control is to maintain two thirds to three quarters of their assets in Treasury bills, with the balance of the portfolio providing margin for their forex positions. The funds’ reliance on margin accounts means that their investments are moderately leveraged plays that require only a limited percentage of correct bets to succeed. On average, a currency trader who’s on the mark only 30 to 40 percent of the time will still be in the money.
