Playing the FX game

Sep 10th, 2013 | By | Category: Alternatives / Multi-Asset

By David Stevenson –

I’ve always had a love-hate relationship with the world of foreign exchange (FX) investing. On paper the global FX markets are hugely attractive to investors, largely because they are so open, so liquid and so broad. That doesn’t mean that making money from them using currency trading, for instance, is even remotely easy. In fact, I take the diametrically opposite view.

Playing the FX game

Making money from currency trading is not easy, says David Stevenson.

Personally, I think currency/FX trading is a mug’s game if you are exclusively concerned with trying to second guess where tomorrow’s currency pair might go. I have good friends who work in enormously well resourced hedge funds with computer centres the size of an average family house…..and even they struggle to make money from FX trading, so god help Mr Smith at 39 Acacia Avenue with their super duper spread betting trading, chock full of leverage to amp up returns.

But this is only small part of the currency game. Mainstream investors most frequently intrude into the world of FX when they decide whether to hedge their underlying bond/equity exposure – we’ve seen an astonishing growth in these currency-hedged funds in recent years, with the WisdomTree Japan Hedged Equity ETF (DXJ) over in the US possibly the most startling success.

Without going into the ins and outs of this debate, I’d suggest that if you are a tactical trader with a 1 to 12-month time frame looking to take a big position on a strong structural theme such as Japan’s renaissance, then currency hedging probably does make sense, although you need to understand how the hedging is actually accomplished (dynamic or monthly) and how much it’s costing you.

Another good, current example is oil where an investor may look to capture the upward trend in Brent but look to hedge out any FX move. For longer-term investors with a time horizon above 12 months I’d suggest staying completely away from hedging, simply because academic study after academic study seem to suggest that hedging doesn’t really add any value and costs a fortune over many years.

More adventurous investors might also be interested in currency pairs as a simple way of playing big macro stories, such as the relative attraction of euro assets versus dollar assets. Again you are using FX as a simple surrogate for a bigger macro investment strategy, and the good news here is that outfits like ETF Securities has a massive, long list of currency pairs, including leveraged versions, that make money both long and short.

If I was pushed, I suppose I’d say that I was bullish the US dollar and bearish the euro, with ETFS Long USD Short EUR (XBJP) from ETF Securities being an appropriate ETP to execute this, but I’d have to issue an important caveat. Although there is a much more linear connection between macro-economic signals and FX markets, making money on that trade requires you to be nimble and smart. For as long as my short-term memory can recall (which is sadly not long) I’ve been short sterling because I think we have some very major structural problems. What has sterling done over the intervening period? Strengthened as macro data has improved! Given this lamentable track record, I’d be equally cautious about the euro/dollar trade – everyone and his dog may think that dollar assets are the place to be but macro data has a tendency to surprise us, and so I wouldn’t be surprised if the eurozone provides positive momentum from hereon in!

Mainstream investors next encounter FX markets when they are seduced into key currency ‘trades’ or strategies. There are a few variations on this theme including:

Carry trades – borrowing in low-rate currencies and then investing in higher-yielding currencies. It’s a great strategy until it isn’t i.e. it works well until we enter a risk-off scenario.

Value/fundamental trades – buying currencies that look cheap compared to their underlying purchasing power. In this game you look at gauges such as the Economist’s Big Mac index and then wait for those expensive currencies in purchasing power parity terms to devalue over time. On paper this is a great trade but boy, you have to be patient!

Emerging markets trades – a really neat idea that involves a simple observation by economists which is that as developing world economies advance and mature their currencies strengthen over time. Again this trade can work a treat until it doesn’t. It can even go badly wrong as countries like China actually end up devaluing their currency in order to fight a slowdown!

Commodity trades – this is a variation on a similar theme, and is a simple linear way of playing rising commodity prices and its effect on key currencies.

One simple way of accessing a number of these strategies is via the innovative db X-trackers Currency Returns UCITS ETF (XCRG) from Deutsche Asset & Wealth Management, the investment management division of Deutsche Bank. The fund tracks the performance of the DB Currency Returns EUR Index, which is a blend of three indices: the Deutsche Bank Carry (EUR) Index, the Deutsche Bank Momentum (EUR) Index and the Deutsche Bank Valuation (EUR) Index. Each of the three underlying strategy indices is assigned an equal weighting and invests in the currencies of G10 countries.

An alternative idea is to buy baskets of currencies i.e. baskets of EM currencies or my own favourite, which is ‘hard money’ nations as an insurance bet to sit alongside that shiny metallic stuff that sits in central bank gold vaults. When all hell breaks loose, investors have a nasty tendency to buy safe-haven assets. The first wave tends to move into US dollars but as the crisis deepens, investors begin to fret about even the durability of the US system, and we start to see moves into Norwegian krone or Swiss franc. Personally I’d quite like a hard money currency basket as a safety play but nothing exists (yet) in ETF land.

WisdomTree in the US by contrast offers both commodity FX baskets and emerging markets baskets, via the WisdomTree Commodity Currency ETF (CCX) and WisdomTree Emerging Currency ETF (CEW), using local money market accounts as a proxy. These funds seek to achieve total returns reflective of the money market rates in commodity-producing and emerging market countries, respectively, and changes to the value of these currencies relative to the US dollar. The commodity currency fund offers exposure to the Australian dollar, Brazilian real, Canadian dollar, Chilean peso, Norwegian krone, New Zealand dollar, Russian ruble and South African rand, while the emerging markets currency fund offers exposure to the Mexican peso, Brazilian real, Chilean peso, Colombian peso, South African rand, Polish zloty, Russian ruble, Turkish new lira, Chinese yuan, South Korean won, Indonesian rupiah, Indian rupee, Malaysian ringgit, Philippine peso and Thai baht.

Again, I think both of these currency basket ETFs are a good idea but investors need to tread with some care. The obvious challenge is that these two ETFs are dollar based, which is a bit of a problem for sterling and euro-based investors. The next issue, especially with the emerging markets basket, is that countries with weak currencies, such as Indonesia and India, are forced to raise their rates to attract foreign capital. The WisdomTree ETFs capture this embedded yield but volatility can be huge with rewards looking fairly meagre – since inception in June 2009, WisdomTree CEW has only returned 11% in NAV terms.

By contrast, investors looking for a simple-to-access version of my hard money FX idea might be better off considering one of the short-maturity investment-grade bond ETFs managed by Pimco in conjunction with Source. The funds are available in sterling, dollar and euro and are an effective way of playing currency rates and local yields.

Looking at markets now, which strategy or trade would I be looking to invest in? My first answer is nothing – I don’t (yet) see emerging market currencies at outrageously cheap valuations nor do I think that hard money currencies are that attractive because of spiking volatility. I’d be cautious about carry trades, as well, in case we lunge into a risk-off seizure.

But I would be looking at one obvious play, which is to look at oil-orientated commodity currencies, which should do well. In particular, I’d be paying close attention to the Canadian dollar, Russian ruble and Norwegian krone. On the short side, I’d be avoiding the Indian rupee, the Turkish lira and Thai baht like the plague over the short term (though I’m actually quite bullish about equity assets in the last two countries long term). I’d wager that oil prices will stay higher for the foreseeable future and that’s bad news for the latter gaggle of countries and good news for those wealthy Canadians, and Norwegians. ETF Securities’ product suite, which includes long NOK and CAD and short INR products, is a good place to start.

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