A Look at Forex Hedge Funds ~ market folly

Monday, March 29, 2010

A Look at Forex Hedge Funds

Liquidity Continues to Attract More Investors to Forex Hedge Funds

While our focus at Market Folly is typically on long/short equity hedge funds, we thought we'd mix it up today and look at an ever-growing segment of the industry. Forex trading is a twenty four hour market that has an enormous amount of the flexibility and liquidity incorporated into its DNA. Forex hedge funds continue to attract investors who want to expand their portfolios, increase leverage, and have better control over risk management. There are different strategies and forex hedge funds can be designed differently, but there is a basic structure that they all adhere to. Some investors enjoy the challenge of only trading the major currencies, while others want to delve into the somewhat uncharted worlds of emerging economies and expanding nations. Other investors like the decentralization that different forex hedge funds offer, as well as the monthly liquidity.

There are several types of forex hedge funds. A Spot Forex hedge fund is not regulated by the SEC or the CFTC, and it offers investors a two day transaction time. A Forward hedge fund is a fund where money is not traded until the specified future date has passed. Another popular forex hedge fund is the Swap Forex fund. Swap fund transactions are done between two parties that agree to trade two currencies with each other for a specific period of time. These currency transactions are not traded through an exchange, and standardized contracts are not used. Another basic forex hedge fund concept is the carry trade, which is one of the oldest strategies in finance. Carry trades occur when an investor borrows money in a currency with low interest rates, and invests it in another currency with high interest rates. Currency brokers realize that past trading patterns show that higher-yielding currencies maintain their exchange rate against lower-yielding currencies, and may even appreciate slightly, which allows the broker to pocket the difference in yields or what is known as the “carry.”

Opportunities in Forex Hedge Funds Strategies?

On March 24, 2010 John Taylor, the chairman of the world largest currency hedge fund FX Concepts LLC, dropped a hint on Bloomberg Television about the future of the Euro’s value against other currencies. It’s no secret that Greece is on the steps of bankruptcy and Portugal is approaching a similar fate. Germany and France's reaction to Greece’s financial debacle has been slow; Germany’s Chancellor said any aid would require help from the International Monetary Fund. The Chairman of the Monetary Fund said that seemed unlikely, so that news put a confidence dent in the European Union, which resulted in the Euro hitting a ten month low of $1.33 against the dollar on March 24th.

The interesting point that Taylor made was that he expected the Euro to fall to $1.20 by August 2010, and the Euro will be the dollar’s weakest counterpart over the next three to six months. Taylor, who manages over nine billion dollars in the FX Concepts Hedge Fund, also noted that some countries in the Eurozone may even be expelled from the currency union in order to bring some sense of stability to the Euro. The EUR/USD trading pair offers forex hedge fund investors some immediate profits if Taylor’s predictions materialize. What's interesting is that while he has many months for this call to play out, we recently saw evidence of hedge funds covering the euro.

The dollar continues to gain strength against the Yen, the British Pound, and the Euro. If that trend continues, forex hedge fund investors can enjoy the benefits of a stronger dollar unless the US economy experiences a set back in terms of increasing unemployment, uncontrolled inflation, or further banking and housing issues. You can also check out a technical analysis video of the dollar here. One of the other opportunities that certain hedge funds are taking advantage of is the appreciation of Asian currency against other currencies. Asia is coming out of the recession faster than other parts of the world, and that fact prompted Taylor to promote selling Euros, and buying Asian currency over the next twelve to eighteen months. This is contrary to what we saw recently as legendary investor Jim Rogers was long the euro.

Other Forex Hedge Fund Alternatives

In the future, we'll look into highlighting some of the prominent forex hedge fund managers. But in the mean time, there are several forex investment vehicles that have attracted investors' attention thanks to their innovative currency hedge fund replication strategies. One interesting forex alternative vehicle is the PowerShares DB G10 Currency Harvest (DVB). This fund uses a quantitative strategy based on academic research which builds a long-short portfolio and uses the carry trade as part of a long term portfolio. Another fund is the iPath Optimized Currency Carry ETN (ICI) backed by Barclays that only invests in G10 currencies. That strategy kept it from losing large amounts in 2008. However, the returns in 2009 were not as great as other forex hedge funds replicators that used other strategies. Another alternative forex fund for investors looking for forex exposure is the commodity managed future fund ELEMENTS S&P CTI ETN (LSC). That fund uses a long-short type momentum strategy and profits from macroeconomic trends but invests across the commodities spectrum and is not limited to just forex like the other funds mentioned.

Keep in mind that two of the funds listed above are exchange traded notes (ETN's) and as such bear counter-party risk. We've touched on the comparison between ETNs and ETFs in the past using oil funds as an example for those interested.

The recent wave of hedge fund replication products has been intriguing and we've criticized hedge fund ETFs in the past. We've also examined mutual funds using hedge fund strategies as well. Those products leave something to be desired and that is a whole 'nother topic for discussion. Only time will tell if the currency funds above will fall under the same category. In mentioning those funds above we just wanted to highlight the various risks associated with them. And as always, this is not an investment recommendation by any means.

That wraps up a brief look at forex hedge funds. This is divergent from our normal coverage as we typically focus on long/short equity hedge funds but we wanted to try and spice things up per some readers' requests. For more on hedge fund forex exposure, head to our recent post that actually showed hedge funds were covering the euro. And for more of our coverage of global macro hedge funds, stay tuned for Prologue Capital's recent commentary that we'll post later this morning.

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