Philip Brass

Accessing Currency Alpha

Philip Brass

There is strong evidence that currency is now seen increasingly as a viable source of Alpha by investors. For instance, CitiFX has experienced a tenfold increase in the value of investment in our CitiFX Alpha product suite over the past two years. These investments have occurred despite the extraordinary period of financial market turmoil, which has seen funds, including currency, suffer heavy drawdown.

There is strong evidence that currency is now seen increasingly as a viable source of Alpha by investors. For instance, CitiFX has experienced a tenfold increase in the value of investment in our CitiFX Alpha product suite over the past two years. These investments have occurred despite the extraordinary period of financial market turmoil, which has seen funds, including currency, suffer heavy drawdown.

Citi's FX Alpha products have a different history to most other FX funds. We started creating them over a decade ago with the establishment of a quantitative team - the Quantitative Investor Solutions Group - dedicated to FX. Led by Dr Jessica James, this was initially an advisory group which developed a broad set of strategies and approaches to Alpha generation using a multitude of indicators as inputs. These range from spot and options to interest rate and macro data.

Around four years ago, a client asked if it could invest in CitiFX's trading programmes. The client recognized FX as an investment uncorrelated to traditional assets, but it did not want to handle the trading process. Since this initial interest, CitiFX has created a series of strategies and portfolios, including: The Classic; The Diversified; The G10 Index; Global Carry and EM Carry. Two of these portfolios are listed UCIT III funds - the CitiFX Alpha Strategy 1 Fund listed in Dublin and the Citi Wegelin Active Currencies in Luxembourg. Over-the-counter wrappers include total return swaps (TRS), fund-linked notes and options.

Transparency and Alpha

Our products have been Alpha-focused, rather than Beta, generators. It is possible to illustrate Beta exists in FX with the example of the carry trade, which capitalizes on the forward rates are rarely an accurate prediction of where a currency pair will be trading in the future. So a simple, rule-based portfolio can be constructed by going long of high-yielding currencies and shorting low-yielding ones. However, it has significant risk in the 'tails' and sudden losses can materialise when it breaks down, such as in 2008. The Alpha component is designed to shield investors from these periodic dislocations.

CitiFX has a very broad spread of different rules-based Alpha strategies and diversification has become an important element that defines our approach relative to many of our competitors. This limits exposure when dislocation occurs in a particular trading 'style', such as momentum or carry.

CitiFX Alpha also believes in transparency. We have published both the articles about our models, as well as defining the investigative process and the key inputs to our clients. This is important, as investors need the right level of information to fully understand what they are investing in.

Accessing Currency Alpha

The process we use to build an Alpha portfolio (see diagram) ensures the creation of a robust fund, which is bolstered by the addition of a comprehensive risk management system called Max Drawdown-at-Risk (MDaR). This has proved extremely useful in enhancing timely risk management, such as in 2008, when many funds were heavily down; indeed CitiFX Alpha's G10 carry strategy still managed to post a positive return.

FX - The perfect asset

FX risk is inherent in most cross-border investment. Many investors now understand this and manage their embedded FX exposure and control it better than they have in the past. The next step is to turn the FX exposure into an opportunity, either as a standalone investment or as a compliment to an underlying portfolio via an overlay programme.

The currency market is perfect for the creation of both Alpha and Beta funds. It is extremely liquid and turnover is concentrated in a relatively few instruments. Even at the height of the period of global risk reduction at the end of 2008 and early 2009, FX stood out the relatively smooth operation its spot, forward and option markets.

However, FX contains various inefficiencies reflecting the many (non-profit maximising) motives that some participants, such as tourists, corporates and central banks, have. FX is not, as often stated, a zero-sum gain. And because the market is inefficient, opportunities exit for profit-oriented professionals to generate Alpha in a variety of trading environments. CitiFX's Alpha products capitalize on these inefficiencies by combining a number of proven, individual trading strategies. This allows them to capitalize on a level of diversification and low correlation between the models, which helps smooth out performance.

Alpha good, but Beta not bad

Looking ahead, CitiFX will expand our Alpha suite of products to cater for the growing investor demand. This will be done along thematic lines, such as Global Carry, G10 Carry and EM carry, as well as through the creation of additional bespoke TRS products. The bank will also launch a suite of Beta-based products, which are attractive to many investors because of their passive nature and low charges. An offshoot from this is the design of an index linked to an underlying currency exposure, such as the currency risk inherent in an overseas bond or equity portfolio.

It is important to remember that although FX trading has existed for centuries, the modern market is still adapting to client needs. Its size, transparency and sophistication, together with its seeming contradiction of being inefficient despite its unique liquidity depth, make it arguably the best asset for investors' next focus.