How To Develop Your Own Currency Long/Short Portfolio

by: Efficient Alpha
By Joseph Hogue, CFA

An article I wrote Monday, the second in a series covering Michael Dever’s new book “Jackass Investing,” looked at commodities and a carry trade using the PowerShares DB G10 Currency Harvest (DBV) as a way for individual investors to benefit from the carry trade. As I did my research for the article, I became increasingly interested in the outlook for some of the more actively traded currencies and how investors could benefit from differing economic environments across the globe.

As I wrote in the previous article, currencies fluctuate due to relative economic strength, expectations for inflation, and interest rate differentials across the countries. Higher interest rates, the primary way a central bank slows inflation in an overheating economy, draws capital inflows from foreign investors looking for a better return. There are a few no-arbitrage intricacies, but that is the general idea behind currency movements. There are quite a few ways to invest in currencies, most do it for hedging purposes but there are also those who use it for return as well. Hedging operations are conducted primarily by companies with cross border revenues or investors with foreign investment exposure. The strategies for hedging are fairly straight-forward, the most popular by far is using futures to remove your foreign currency exposure. As an owner of Colombian real estate, I use futures when I want to lock in a good price for the peso and stabilize my revenues from rents.

The return strategies are where the money’s at, and admittedly the risk as well. I do not get into the more creative trading strategies of the forex pros but will occasionally put on a long-short pair trade. A pair trade is when an investor buys one asset and simultaneously sells another asset of similar characteristics and in the same amounts. There are a couple of goals to this trade.
One, you are trying to profit from your analysis of the investments on the long and short side. Many investors only focus on picking good potential investments, i.e. stocks that will increase in value. Anytime you limit yourself from an entire strategy, i.e. picking poor potential investments for short-selling, you are placing yourself at a disadvantage to other investors. The fourth installment of our series on Dever’s book, out on Friday of this week, will cover short-selling in more detail including some trading strategies. There are some significant market characteristics that give short-sellers the advantage and you should at least give it some thought.
A pair trade also helps to remove specific market influences from your investment. While some of the larger, systemic influences (i.e. the European debt crisis) are more difficult to remove from your trades, other regional and country-specific issues can be removed. For my currency pair trades, I usually start with a global macro outlook and contrast it with the extremes within the universe of countries’ outlooks.
The global outlook is weak. The three largest contributors to the world economy; the European Union (26.1%), the United States (24.8%), and Japan (11.1%) are all looking at sluggish growth or an outright return to recession. Almost two-thirds of the world’s economic engine will not be running at peak performance for at least a couple years. This is why I am looking at emerging market consumer staples and construction for my stock portfolio. Because of low or no-growth, the rates in these developed regions will stay fairly low for the foreseeable future. Bernanke has all but taken a blood oath to keep U.S. rates down through 2012, and the chorus is growing for a rate cut by the ECB. Inflationary fears are moderating as the economic situation looks even more dire. The August core inflation number was unchanged at 1.6% in the states, and though the euro zone number has edged up to 3.0% I think it will stabilize in the next few months.
Contrast this global picture with the outlook in individual countries and you begin to get a sense of where to park your money not only in currencies but also other assets. While inflation expectations picked up through 2010 in most of the emerging world, they have moderated with the weakening global outlook. Many of the emerging worlds’ central banks have adopted explicit inflation targeting and will aggressively counter any return of devaluation. This means that interest rates throughout Latin America, Asia, and the MENA regions are more likely to stabilize or increase rather than be cut. Of course, investors will not be able to totally divorce their portfolios from euro, dollar, and yen problems but the world isn’t entirely dependent on these three. Organic growth and export demand to China will provide enough economic stimuli to help the rest of the world perform relatively well. Finally, trade issues between the U.S. and China will mean that the Chinese government allows the Yuan to slowly appreciate. It may not happen quickly, but it’s about as close to a sure bet as I’ve ever seen.
Following are six currency funds that investors could look to for long-short ideas given our global and regional outlooks. Though emerging market currencies provide a clearer example of the differences between currency return drivers across the globe, most investors are not as comfortable setting up trades with these less liquid and more volatile assets. The funds below invest in the more liquid, developed market currencies.
The CurrencyShares Australian Dollar Trust (FXA) is designed to track the price of the Australian Dollar net of expenses (0.4%) which are paid from the interest rate earned on the deposited currency, currently at 4.69%. The Aussie has benefited considerably as investors look to countries with relative economic strength and less macroeconomic risk than the European or U.S. currencies. Bloomberg reports that evolving events in the European debt environment should contribute to a risk-on trade and help push the Australian dollar higher. I would play the Aussie as a safer long bet. If the world economy improves and commodity prices improve, money flows will continue into the currency. If the global economy gets weaker, the Aussie will still return a respectable rate from continuing high rates though outflows from risk aversion could weaken the currency.
The CurrencyShares Canadian Dollar Trust (FXC) is designed to track the price of the Canadian Dollar net of expenses (0.4%) which are paid from the interest rate earned on the deposited currency, currently at 0.65%. The CAD, like the Aussie, is largely influenced by commodity prices and the risk trade. Again, it is a much safer long bet than using one of the emerging market currencies like the Brazilian Real or the Korean Won. Though the second quarter GDP figure was down on a year-over-year basis, this was largely a result of higher imports and the economy is seen as relatively strong going forward.
The CurrencyShares Japanese Yen Trust (FXY) is designed to track the price of the Japanese Yen net of expenses (0.4%). Expenses are deducted from the assets of the fund since there is no interest rate earned on the deposited currency. The government recently announced that it would issue up to 15 trillion in yen to expand its efforts to fight appreciation versus the dollar. This kind of explicit policy, combined with industrial production coming in below expectations and falling manufacturing PMI, should keep the Yen down relative to other currencies.
The CurrencyShares Euro Trust (FXE) is designed to track the price of the Euro net of expenses (0.4%) which are paid from the interest rate earned on the deposited currency, currently at 0.65%. French President Sarkozy and German Chancellor Merkel have set a November 3rd deadline to deliver a plan to the Group of 20 on how to respond to ‘structural defects’ in the 17-nation euro area. This commitment, combined with what Bloomberg attributes to a rebound from the short trade, is helping to support the Euro this week and last. Nevertheless, even a well-planned aid package or commitment will be difficult to implement and the region’s economy will not recover quickly. While the Greek parliament has surprised many with its ability to push through aid-contingent reforms, I do not have much faith in the region’s commitment to austerity measures.
The WisdomTree Dreyfus Chinese Yuan Fund (CYB) seeks to achieve total returns of both money market rates in China available to foreign investors and changes in the value of the Chinese Yuan relative to the U.S. dollar. The expense ratio of the fund is 0.45%. Bloomberg reported Monday that the Yuan is appreciating strongly on continued forecast for gains and an aim to alleviate tensions with Washington. The Yuan was the only currency of the 25 developing-nation currencies tracked by Bloomberg to appreciate in the third quarter. Policy makers in Washington will vote on Tuesday to permit punitive measures against Chinese exports despite President Obama warning that the measure could spark a trade war.
The PowerShares DB US Dollar Index Bullish Fund (UUP) is based on the Deutsche Bank Long US Dollar Index and uses long futures contracts to replicate being long the US dollar against the following basket of currencies: Euro, Japanese Yen, British Pound, Canadian Dollar, Swedish Krona and Swiss Franc. The fund charges a management fee of 0.75%. In addition to our sub-par growth outlook for the country and rock bottom interest rates, Fed Chairman Bernanke has recently said that the Fed has additional tools to respond to economic weakness. This is a direct reference to further quantitative easing which, in the past two recent attempts, has led to dollar weakness and asset inflation in EM and other markets. This in turn leads to rising rates and appreciating currencies for some of our long trades.
The table below shows the correlations between the six funds over the last year. The dollar bull fund is the only fund with a negative correlation to the others. Most other pairs have low, positive correlations. The performance of this sample portfolio (Long the Dollar, Yen, and Euro while Short the Aussie, CAD, and Yuan funds) has returned -0.11% over the last year and 13.2% over the last three years.
Given this outlook, one might go long in the Aussie, Canadian dollar, and Yuan while shorting the Euro, U.S. dollar, and Yen. The funds above can be used if the investor is not able to access the actual currency market directly. The trade will require the investor to stay informed on the three return drivers. Direct access into the currency market will mean higher potential returns, given the use of leverage, but novice investors might want to stick with smaller bets using the funds as trade vehicles.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.