Sticking to what works with currencies

e-Forex talks with Philippe Bonnefoy, co-founder of Eleuthera Capital AG

First Published: e-Forex Magazine 47 / Tradertalk / April, 2012

Philippe how long have you been in the currency business and what attracted you to the industry?

This will be my 30th year in the financial markets.  During my career I have invested across all major asset classes.  I began actively trading currencies in the early 1990s when I was responsible for a very large global macro proprietary trading book.  The fascinating thing about investing in currencies is that no day is ever the same.  One has to continually observe the price action of the markets and evaluate the responses of other participants to news, economic data and political events.  George Soros alluded to this behavioural approach in his theory of reflexivity.  John Maynard Keynes also described the idea of “gaming” crowd behaviour in his famous analogy of comparing investing to that of beauty contests, in 1936 he wrote, “It is not a case of choosing those which, to the best of one’s judgement, are really the prettiest.  We have reached the third degree where we devote our intelligences to anticipating what average opinion expects the average opinion to be.”  

My educational background is in economics and international studies and I really enjoy analysing political and macro-economic events, but over the years we have adapted our trading approach to be much more focused on what is essentially behavioural psychology.  We analyse what the market participants are doing by tracking them as they leave their footprints in the price action.  Each morning it is exciting to see what happened overnight and every day is like a three-dimensional chess game.  One can never know enough about markets. 

When did Eleuthera Capital commence operations and what trading and investment services does the company provide?

Eleuthera Capital AG commenced operations in Q3 2011.  We decided to set up a new investment advisor solely focused upon systematic currency trading.  After selling my previous alternative asset management business in mid-2007 we wanted to explore new ways to trade macro strategies that could produce extremely attractive risk-adjusted returns in a predictable, repeatable and systematic way.  We wanted to combine trading indicators we had previously used into a highly filtered and systematised decision making process.  After several years of research, testing, implementation and incubation trading and a few million dollars of development costs, we were ready to deploy these models into a currency fund open to outside investors. We accepted a managed account and started a Cayman fund at the end of last year.  We are also planning to launch an Irish UCITS fund with Newscape Capital,  a London-based investment group, where I am Chairman.  

Sticking to what works with currencies

Who are the key members of your team and what are their main day to day activities?

Riadh Fessi, my partner for six years, is in charge of trading.  He became responsible for much of the final build-out of the trading system.  We are both active in ongoing research, testing and portfolio construction.  All the technology trends favour our kind of business.  The evolution of Cloud Computing, dark fibre, co-location, and the serious expansion of e-trading businesses at the banks all positively affect our performance and make us even more competitive.   Furthermore, these major structural shifts in the way foreign exchange trading can be managed and operated mean we need little in the way of human resource.  Essentially, all the heavy lifting has already been done over the last several years.

We are talking of course about automated trading. By design, automated trading systems require almost no human interaction as all electronic currency trades are STP’d (“Straight Through Processed”) through to our prime broker.

Our excellent head of mid-office has simply to monitor our real-time operating and settlement systems rather than spending time in the reconciliation process.  Many operating functions have effectively been outsourced to our partners.  We have several IT, data storage, data processing and Cloud Computing solution providers.  Our fund accounting is performed by Apex Fund Services, an independent fund administrator who produce our weekly NAVs.  I perform the risk management function.  Risk management parameters have already been completely integrated into our investment process so my job is to ensure the portfolio is in compliance with our programmed risk parameters.  In terms of disaster recovery, our business is securely and completely in “the cloud” allowing us to access our trading systems and real-time position monitoring from anywhere in the world at any time.  Our primary system operates out of NY4 in the US and our back-up roll-over system is based in the London area.

How would you describe your investment philosophy and what do you consider to be the key strengths and operational advantages of Eleuthera Capital’s investment services?

We are probably unconventional in the fact that we believe that markets are not efficient which happily defies the last fifty years of finance theory developed by  Dr. Farma at the University of Chicago.  We agree with Lord Keynes who wrote that markets are impacted by “animal spirits.”  One can notice this almost everyday.  Some days markets hugely overreact to an unexpected data release or news item – some days there is no reaction at all.  These animal spirits can drive huge price changes, particularly in currencies.   Perhaps the more common contemporary description for this crowd behaviour is “risk-on/risk-off.”

Please tell us a bit more about what you mean by these “animal spirits?”

A perfect example has been the recent history of the Australian dollar.  In a 16-month period from 2008 to 2009 the Australian dollar/US dollar exchange rate fell 40% and then rose 56%.  Was there a huge decline and then boom of the Australian GDP?  No - Australian GDP actually grew mildly during this period with one only one quarter of small negative growth (4Q 2008, -0.9%).  How does this wild exchange rate movement fit the description of an efficient market?  Long ago we recognised that markets may align with fundamentals, but the reality is in the short and medium term prices can, and will, move all over the place.  As a fund manager, had you been bullish (correctly) of the Australian dollar you would probably not have had any clients left had you held that long Australian dollar position; notwithstanding the fact that had you bought the high in 2008 you would have had an annualised return to date of about 7.5% (had you bought the low you would have had an annualised return of approximately 27.5%!). 

Our investment philosophy has been centred on the creation of an investment process that seeks to create a repetitive, uncorrelated and positive series of risk-adjusted returns.  We want to harvest alpha from market noise – or in other words track the “animal spirits” and capture them!  We recognise that markets “range trade” rather than trend for the majority of the time.  So we created two groups of trading models.  One set of models are centred around mean reversion, selling the highs and buying the lows of the recent trading range.  The other group of models becomes active when markets are short-term trending and those models trade in the direction of that trend.  

One of the problems of currency investing is that prices tend to breakout and then trend and then stop and range trade for long periods before breaking out and trending again.  Some managers do well in trending markets others do well in range trading markets, rarely do managers do well in both types of markets.

We have developed a process that seeks to ensure that we do well in both environments.  Our key strength is that we are very experienced investors who have lived through almost every type of market condition.  We don’t try and think up great theories and then relentlessly test and optimise them until they fit the real world.  We take the real world, and what we have seen work in the real world, and we systematise that.

Sticking to what works with currencies

What style of trading do you undertake to execute strategies and do you have any particular preference for specific trading time horizons, such as intra-day or medium to long term?

We use a comprehensive range of filters in order to screen out most sub-optimal trades. We prefer to be out of the market rather than to be active in trades which we believe may have a lower probability of success and we don’t mind sitting in cash waiting for attractive opportunities.  We use multi factor models that generally involve the following groups of market studies:  pattern recognition, statistical distribution, fractal analysis, momentum oscillators, directional filters, technical analysis and proprietary studies.

Our trading horizons currently vary from about five minutes to eight hours.  We can hold positions overnight, but because we thrive on volatility if markets become becalmed we usually exit.  There are few other participants in these time horizons because very short-term traders are often high-frequency trading in the sub-minute or even sub-second periods.  Most trend traders are trading medium-term trends of 30+ days; traditional short-term trend traders are usually participating in trends that are five days and longer.  So we don’t have a lot of competition in our time horizons.

The best thing about our trading style is we create great portfolio diversification for institutional investors.  We have the most opportunity when markets are volatile – conversely these are often the worst times for equities and many fixed income strategies.  When volatility is low in currency markets, as it has been recently, it is often the best investment environment for equities and bonds.  Witness, for example, the rally in world equity markets from late November to February.  The S&P 500 was up 18% in three months, whilst currency volatility dropped to four-year lows.  Most short-term currency traders reported break even returns for this period, but when equity markets were falling last year our incubation trading accounts made solid gains.  So we have the ability to preserve capital in good times for traditional asset classes and make outsized returns in more difficult market conditions. 

Sticking to what works with currencies

What Risk Management frameworks have you developed and how do you apply them with respect to different strategies and trading models?

Everything we do begins and ends with risk management.  Trades are sized based on a risk algorithm and every trade is initiated with an initial stop – the exact amount that we are prepared to lose on any single trade.  The stop may become dynamic and and convert to a trailing stop in order to further preserve capital and lock-in profit.  If the portfolio begins to become overpopulated with positions another risk algorithm will start reducing the size of additional trades in order to constrain further risk exposure.  The entire portfolio management process is constructed around the size of drawdown that we expect to have.  Trades are sized, stops are calculated, and the portfolio constraints are operated in this way.

We expect that a normal drawdown can be up to 5% in any one month and we have a risk-targeted tolerance to an approximate 10% peak-to-trough drawdown.  We could easily further limit these risk factors – but we feel that they are of the appropriate size to allow us to fulfil our desired objective of an annualised net return of 15-25%.   Generally we recover from drawdowns very quickly so we would not expect to languish in a drawdown for any material period.

What currencies do you trade?

We electronically trade the spot cash market in the major currency pairs and their crosses.  We don’t trade emerging markets due to their lack of consistent liquidity and the high trading costs rooted in the fact that they have wide bid/offer spreads.  In the developed currency markets high frequency trading has helped to dramatically reduced bid/offer spreads – so we like HFT traders even if we don’t fit into that category!  The generic spot market is now almost completely electronic.  One senior FX banker told me last week that they just do not want to have any voice execution any more as it slows down their STP settlement process, and so we find that voice trading of developed spot currency markets is increasingly anachronistic.

How much reliance do you place on the latest automated trading toolsets and execution algorithms to help you better manage risk, optimize trade execution pathways and meet your investment objectives?

We believe that we are on the cutting edge of automated FX price aggregation.  We receive extremely good pricing from the major banks because our style of trading is attractive to bank counterparties as we are often adding liquidity to markets when it is needed. In our trading style, it is not unusual for us to be loss-making in the first few minutes after trade inception as we are often entering markets just when short-term trends are changing.  This means that when banks take the other side of our trades they are still able to profitably cover their exposure to us.  This makes our strategies very scalable – in the world’s deepest markets.  We have developed our own execution strategies and we have our external IT partners refining some new execution algorithm strategies for us.

Sticking to what works with currencies

How do you go about back-testing your proprietary currency trading systems and signals to confirm that your strategies will perform as required?

We have been testing models continuously for five years.  The way things develop is that Riadh or I toss out an idea about a possible model and then we think about how that would work and whether it is complementary to our existing model sets.  We then begin building it out and thinking about what time period may be appropriate.  Most of our model sets spend the majority of their time looking at 1-minute to 240-minute time “slices.”  We analyse the change of market conditions within that time period and compare it other time periods.  Once we are comfortable that a new model could be an interesting portfolio addition we begin a series of tests.  

It is not unusual that due to all the filters that we usually deploy, a single test using only one year of tick data could take a week of 24-hour computing time to complete.  We are analysing all the iterations of every bid/offer spread, 24 hours a day for approximately 250 market days a year.  To test several years of data and then study the results and make any necessary changes may take several months.   What many people do not necessarily appreciate about our testing methodology is that for us to test a single calendar year of intraday data, on a single model, on a single currency pair, would equate to a medium-term trend follower testing over 86,000 years of a daily data series. 

We prefer the testing process to be, as close as is possible of course, to “real world” conditions.  I have long since given up printing the test results as we filled one room in Switzerland with binders of test ouputs.  We increased our growing collection of multi-terrabyte external drives to store cheaply and efficiently what has become a vast array of data storage, the likes of which if printed on paper would now take a large warehouse to store. 

When we are happy with test results (which is a about 5% of the time), we initiate the model into a separate live Demo server for observation.  This typically runs for a month or two on live data, but without live execution, in order to make sure that the observed results are in line with expectations.  If we are pleased with the results then we initiate a test with proprietary capital in a separate account for several months in order to make sure the actual results generated are as to be expected.   You can begin to see why it was over three years before we first launched our incubation account!  We don’t know too many firms who have enough conviction in their models that they are prepared to fund three years of research without any revenue.

What trading platforms do you use and what factors influenced your choice?

We spent the first couple of years giving out projects to external IT and algo consultants. Unfortunately we found them to be expensive, arrogant, slow and poor project managers.  We then brought our programming resourcing in-house and we used MATLAB and C++.  We found this process was also slow and liable to error between what the programmers crafted and what we wanted.  The final outcome is that after experimenting with a number of external and internal solutions we found that MT4 could do about 80% of what we needed and it was a very easy and flexible system for us to update and modify.  We commissioned the additional add-ons that we wanted and then we experimented with a couple of bridge providers before settling on PrimeXM.

How did you go about building your trading desk IT infrastructure and was the trading software and connectivity technology provided by third party vendors?

We originally started internally, then we bought a server to plug into a data center and then we finally went for a secure Cloud Computing solution.  We still use our own server for testing and we use servers in both London and NY to demo test and to trade.  We want our trading servers to be close to the bank servers.  We have an IT service firm in Switzerland that we have used for many years to provide our basic IT infrastructure and two separate cloud providers and PrimeXM GmbH for our bridge and aggregation solutions. 

What new strategies and products have you been exploring as part of efforts to widen your range of trading ideas and investment solutions?

We experiment all the time.  The recent trend has been to move to shorter-term time periods.  Our current trades generally have duration of 4-8 hours.   The models that we plan on bringing on line operate in the two–to-thirty minute time horizon.  We don’t feel that we currently have the interest to start trading in the sub-one minute time arena.

For those investors seeking currency returns from a managed account program, what advice would you give with respect to their choice of currency manager?

The currency market has a turnover of over $4 trillion a day and it is a surprise, for a market that trades at many multiples of the total value of all daily global equity market volume, that there are so few dedicated currency managers.

Many currency managers fall into one of two categories:  medium-term trend or carry traders.  We do neither.  The reason that we do not invest in these strategies is that they are highly correlated not only to each other – but also to other asset classes.  Carry strategies, buying a high yielding currency and borrowing in a low yielding currency, creates a positive interest rate spread.  It is also easily leveraged.  The problem with this strategy is that it becomes easily crowded – and it feels like free money.  Many investors deploy a degree of leverage in executing this strategy and so you end up with a boom and bust cycle.  As an example, the Korean won was a great carry trade for most of 2011 until September, when it promptly lost 14% of its value.  The main reason that this loss was so large was that all the carry investors tried to exit a typical high yielding currency in a very short period – who takes the other side of this exit trade?  Most high yielding currencies just don’t have sufficient market depth, adding an unacceptable and unquantifiable risk to this investment thesis. 

A medium term trend follower will end up with many of the same positions as the carry traders.  Their systems will identify the momentum of investors buying into the high yielding currency and they will follow them in and they will also try and exit when the trend turns, exacerbating the price movement.  In essence both these strategies produce the same correlated return.  The other problem is that the same “risk-off” catalyst that caused the investor exit out of higher yielding currencies probably caused equity prices to fall – so you may end up with unwanted correlation to equity markets.

My advice is to seek diversification amongst managers of any asset class.  In terms of managed accounts and managed account platforms, investors should closely examine what are the additional costs to host a managed account.   The main reason that investors have had an interest in managed accounts in recent years is their concerns about fund liquidity, transparency and the accurate marking of positions. The currency markets are extremely liquid, as such currency funds should offer extremely good liquidity terms, and the marking of positions is not really subject to discretion, as example, the price of EUR/USD is universally available.  So the question remains, do the benefits of a managed account justify the extra fees over investing in the fund?

We operate a managed account on behalf of an institutional investor.  It works well because we have good autonomy on how it operates, its trading infrastructure and with which counterparties it trades.

We have made sure that the Eleuthera Currency Fund is getting the best possible pricing.  We have developed a superb multi-bank, multi-ECN executable pricing feed.  This kind of set-up may not be available in some managed account platforms.   

Ultimately, we are fiduciaries and our job is to help investors achieve their risk-adjusted return objectives.  We are counterparty and investor friendly and we believe that true investment success is built through finding long-term sustainable partnership solutions between all stakeholders.

Do you think the currency fund management business is getting harder in terms of delivering consistent returns?

We think it may be getting easier.  Some of the more difficult years were 2005 and 2006 when low volatility created few opportunities for currency managers.  Many managers produced low single digit returns when equity and credit markets were booming. Thus a diversified portfolio including all asset classes should perform well.  In periods of high volatility, short-term currency trading returns should perform extremely well – when other asset classes are under stress.

When equity markets became more difficult the diversification benefits of investing in currencies also became apparent.

One reason that we think that the FX market is getting easier is that lower trading costs are enhancing our returns.  In addition, the fact that S&P 500 is 12% below its price 12 years ago has helped devalue this cult of equity that indoctrinated investors in the 1980s and 1990s.  This has forced investors to focus on attractive returns available in other asset classes.  Very, very few investors have bothered to allocate to currencies as a stand alone asset class.  Consultants don’t now how to benchmark it, investors don’t know how to classify it, and only now are they are some institutional investors beginning to recognise that currency trading can be an attractive risk diversifier for their portfolios.

Due to its liquidity, simplicity and transparency and it has to be said, due in no small part to the explosion in the popularity of retail forex as a global phenomenon, the next big growth area will be the recognition of FX as a major asset class.  It is long overdue and the possibilities are vast.

Looking ahead, how will you be addressing the main challenges facing Eleuthera Capital as you seek new ways for capturing and exploiting investment opportunities with currencies?

One point that is often overlooked by investors is that the currency market is perhaps the only market in the world that participants do not all share a similar profit maximising objective.  A large portion of the currency market is comprised of corporate treasury managers whose sole objective is to transfer cash balances between various markets where they have to pay invoices or receive payment for goods and services.  Sometimes they need to hedge out future exchange rate risk.  They all share a common trait – they must execute a transaction that in itself is not profit seeking.  This throws out many possibilities of alpha generation for us – these transactions often create short-term market distortions that we are able to exploit.  In essence we can create profits by bringing the market back into equilibrium helping accommodate the daily trade flows of commercial transactions.

Our future management efforts are concentrated on two areas – striving to make our investment processes, risk management and trading models the absolute best that they can be and continuously researching new trading ideas.  The dinner table conversation of our investment team usually involves discussing new or possibly better way of currency investing.  Our focus is on shorter-term time horizons for a number of reasons.   The objective is to be like a tollbooth on a highway.  We want many trades going through generating modest, sustainable profits every day.  In the shorter time frames the inevitable drawdowns can be absorbed and regained swiftly.  We think that in this way we can monetise the market “noise” and create a higher quality and lower risk investment return for our investors in almost all market conditions.

We believe that by deploying decades of trading experience into a systematised investment process, and by continuing to implement new and evolving models, we can generate very attractive risk adjusted returns for years to come.

Sticking to what works with currencies