The fund seeks to profit from the higher yields paid by some currencies compared to the euro, and to benefit from structural changes and trends in emerging economies and currencies. It has an established track record, a simple and transparent process that seeks steady alpha generation and low correlation with traditional asset classes. This is all provided within a UCITS III framework with weekly liquidity.
The forex market: a little-exploited territory
With a daily trading volume of €3 trillion, the forex market is the largest and most liquid of the world’s financial markets. Since it is virtually uncorrelated with the traditional asset classes, this market provides a worthwhile diversification route. However, the usual means of investing in it suffer from some considerable drawbacks that make it an as-yet little-exploited territory.
The most obvious way to participate in the foreign exchange market is to buy or sell currencies by betting that they will appreciate or depreciate. Unfortunately, it’s easier said than done and the funds that follow this strategy – which are mainly hedge funds – usually use considerable leverage in order to enhance returns and their results are highly volatile, or even downright disappointing. Other products that seek to take advantage of the well-known “carry trade”, that is, the interest rate differential between two currencies, by taking out loans in the low-interest currency and investing in the high-yield one, are also characterised by substantial leverage and therefore involve a significant downside risk.
Investing in high-yield currencies
A much more worthwhile – and in the end far more conservative – option is to take advantage of the high interest rates paid by certain currencies. While the idea of investing in exotic currencies may seem risky, in actual fact many academic studies have shown that, in general, the additional yield paid by the high-yield currencies more than compensates for their objective risk of depreciation. In other words, there is a kind of “emotional premium” that those currencies have to pay to attract investors and of which the fund’s investment strategy seeks to take advantage.
Moreover, while emerging currencies have historically been weaker than the ones in developed countries, we could see a reversal in this trend as the fundamental situation of many emerging countries is much better than that of the principal developed countries, be it in terms of their growth rate, level of debt or public deficits. As a consequence, this situation even allows us to envisage an appreciation of some emerging market currencies.
Which strategy to adopt?
Rather than buying the exotic currency and then investing in time deposits with banks of the country in question, the strategy developed by SYZ Asset Management replicates this process by buying the selected currency through a forward contract and then reselling it at the spot rate at maturity. This technique allows the interest rate differential with the reference currency (EUR) to be captured automatically but has the advantage of limiting the counterparty risk.
The investment universe is the most liquid currencies in the combined MSCI World and MSCI World Emerging Markets Indices. In order to obtain a good level of diversification while focusing on the most worthwhile currencies, each month the managers select the five currencies having the best risk/return ratio, measured by the interest rate differential with the euro, divided by the expected volatility. In this way, the fund is agnostic in terms of currency forecasting, and instead focuses on the top five currencies with the best prospects at the time. Managers then build an equally-weighted basket of the selected currencies using one-month FX forwards or FX non-deliverable forwards (NDFs). Cash is mostly invested in short-term deposits, but may also be treasury bills. The result is a diversified portfolio that is only weakly correlated with traditional asset classes and involves no leverage. In November 2010, the five currencies selected were the Australian dollar, the Indian rupee, the Indonesian rupee, the Polish zloty, and the Turkish lira.
Macro-economic filters
The main investment risk in high yield currencies is that of a sudden devaluation. In order to limit this risk, SYZ Asset Management has developed proprietary macro-economic filters that are activated in periods of turbulence in the financial markets. This is because when equity markets are very volatile, investors tend to revert to safer assets and therefore to liquidate their positions in countries with fundamentals that are deemed more fragile, a movement that in turn may trigger a sudden drop in their currency. These filters are based on conventional macro-economic data (current account deficit, tax deficit, inflation, economic growth) but also on market indicators such as sovereign CDS spreads. As a result of implementing these filters, the managers withdrew the Hungarian forint from the portfolio in April 2010, just before the euro crisis. Moreover, if unforeseen events occur, the managers may at any time decide to liquidate the positions in a currency in the course of a month. This was the case notably with the Mexican peso during the outbreak of H1N1 influenza in Mexico in April 2009.
In summary, OYSTER ForExtra Yield conducts a systematic monthly rebalancing of its foreign exchange allocations focused on selecting the five currencies with the best risk/reward ratios at that time. It uses risk-adjusted criteria for currency selection, employs no leverage (100% exposure at each rebalancing) and makes use of a proprietary algorithm integrating macroeconomic filters to limit drawdowns during turbulent periods.
