FX Protected Carry is an investment strategy that aims at exploiting interest rate differentials between different countries. Its design allows it to collect interest rate premiums from the most attractive high-interest-rate countries via forward foreign exchange transactions. Additionally, Metzler's award-winning Systematic Currency Overlay is added to the strategy's funding component in order to minimize exchange rate losses when high-interest-rate currencies go into decline. As the strategy shows very low or even negative correlation to global equity and bond indices, FX Protected Carry can be looked at either as a useful portfolio addition via the existing UCITS vehicle or as a serious alternative to local currency money market instruments and even to local currency bond investments.
Generating risk premiums
The FX Protected Carry strategy invests in high-yield currencies via forward exchange transactions. The interest rate advantage of a high-interest currency includes a risk premium over a low-yield currency. This premium is meant to compensate for the higher risk of exchange rate depreciation when holding a high-yield currency. While the strategy consciously invests in the high-yield currency aiming to collect the risk premium, it is also designed to protect investors from heavy devaluation via active risk management. This way volatility is kept low and contained while carry returns are being generated.
High-interest countries are target markets
The investment universe of the FX Protected Carry strategy includes all liquid currencies worldwide that can be traded via forward foreign exchange transactions as well as via non-deliverable forward transactions. At the beginning of each calendar year, our self-developed models select the five most attractive high-yield currencies that will be traded throughout the duration of the calendar year. One of the key criteria for selection is that the spread between the high-yield currency’s interest rate and the US interest rate has to be positive. Another key determinant for selection is the particular currency’s likelihood to trade in a stable trend and thus its ability to generate not only carry income but also trading income through our systematic trading models.
At the portfolio construction stage, each of the five high-interest currencies is assigned a maximum weighting of 20%. For managing the five currency pairs, we use five models each – a total of 25 models. Whether funding is in euros or US dollars is determined in five steps by our systematic Currency Overlay tool. This leads to long positions in US dollar.
Investing via forward foreign exchange transactions
The forward foreign exchange rate is calculated based on the current spot market rate and the interest rate spread between the investment currency and the funding currency. Currently, for example, the Turkish central bank’s repo rate is 12%, while rates are negative in the euro zone. Thus, the Turkish lira can be bought forward against the EUR more than 12% cheaper than its current foreign exchange spot rate. Assuming that the foreign exchange spot rate does not move at all throughout the calendar year, an investor in Turkish lira would be looking at a 12% profit by year end. If the lira appreciates, there are additional profits to look at, while if the lira depreciates, the trading models will likely generate exit signals which will help protect profits. The interest rate differential creates an additional buffer here.
A multi-model approach to managing foreign exchange risks
Our Systematic Currency Overlay is a risk-management tool developed in-house and aimed at managing foreign exchange risks. It won the European Pension Award in 2017 in the category “Currency Manager of the Year” against most reputable competition.
It is applied to the FX Protected Carry strategy and typically leads to the following positioning: in a risk-friendly environment, high-yield currencies tend to perform well while the USD can be expected to be somewhat weak (see Chart 2, Quadrant 4). In this case, the models will typically favor funding in USD over EUR. In a risk-averse environment, on the other hand, high-yield currencies typically will trade weakly, while the USD is likely to be strong. Based on this approach, our models have proven successful, even during the crisis years 2008/09. Once a high-yield currency starts to drop, the models will begin to trade out of the currency in multiple steps until, in an extreme case, the position is closed out completely. As these decisions are taken using quantitative models only, there is no scope for discretionary trading decisions. In 2018 for example, during a period when emerging market currencies were trading very weakly, the FX Protected Carry strategy was still able to generate a positive return, albeit a small one.
An alternative to money market instruments or emerging market bonds
Foreign exchange forwards are more actively traded and thus significantly more liquid than emerging market bonds. Although bonds will usually offer slightly higher yields, they also come with higher credit and liquidity risks. Especially in times of crisis, these risks should not be neglected. Forward foreign exchange transactions, however, remain liquid even in a risk-averse environment and, thanks to daily collateral management with the counterparty, default risk is practically non-existent. Transaction costs are very low, due to our best execution policy and direct access to the interbank foreign exchange market with over 50 banks and brokers at the other end.
We believe that the long-term prospects for emerging markets are positive, even though highly speculative short-term positions often lead to significant declines in these markets. We have therefore decided to be invested in these markets via the ART Metzler FX Protected Carry strategy, but we use our model-driven Currency Overlay tool to reduce drawdowns in difficult times and even have earnings potential via US dollar positions in such an environment.