Previously we have written about our active-beta strategies and how we are applying them to equities and fixed income. We also mentioned how we were working on a solution to systematically take advantage of the carry trade. After a lot of research we have finally devised an acceptable method to capture returns while at the same time minimizing drawdowns.

In the initial stages of research we did a lot of search and came across a few good and several bad ideas. One of the most insightful things we read came from Macro Man . He wrote where he uses a volatility filter to tell him when it is a good time to be involved in the G-10 carry trade. After further research we found it to be true that the best time for the carry trade is when things are fairly stable and volatility is low or declining and the worst time is when it is high or rising. This of course makes sense since the majority of this strategy revolves around trying to capture interest rate differentials from high yielding currencies versus the low yielding currencies. When excessive volatility comes into the market many participants will start to unwind their leveraged positions and in so doing they can wipe out a lot of gains from the carry. Using a volatility filter helps to sort out the high, moderate, and low risk times. For the most part we want to be involved in the moderate and low risk times and step aside in the high risk times.

Of course volatility is not the only risk to the carry trade. Anytime a central bank decides to change rates the carry will change and depending on what they do you can make or lose money. Also if a few large market participants quickly unwind positions you can get hit before the filter is triggered. What we have attempted to do is to simply eliminate a regularly occurring risk and improve our risk-adjusted returns by avoiding that risk.

Some investors new to currency trading might be wondering what is the carry trade? It is when you go long a high yielding currency and go short a low yielding currency. The G-10 carry trade is simply to go long the three highest yielders and go short the three lowest yielding currencies. Right now for instance you would be long the New Zealand Loonie, Australian Dollar, and the Norwegian Krone. You would go long these against the Japanese Yen, US Dollar, and Canadian Dollar. In a currency account you can put these on and then decide how much leverage you want to use. If you are new to currency trading and/or are constrained in your trading instruments you can just buy the DBV-Deutsche Bank G10 Currency Harvest ETF. It does exactly this strategy and applies 2X leverage. Since TheMacroTrader.com trades ETF’s we use the DBV to take advantage of the carry trade.

Happy Trading,

The Macro Trader

P.S. If you have any questions regarding anything we have written feel free to e-mail us or leave a comment. We enjoy and usually learn from reader feedback.

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Active Beta? What’s that? It is our term for a systematic and relatively passive way to enhance returns by capturing risk premia but at the same time manage risk and provide a real long term edge over standard buy and hold.

Having read countless books and papers preaching the long term upward drift in stock and bond prices we realize that risk premia is a good thing. Of course after having come through the 2000-2003 bear market we also know that if risk premia is good then risk management is even better. After reading Jim Leitners’ interview in the book Inside the House of Money we started to look at different ways we could gain more exposure and safely earn risk premia by using systematic strategies that have us involved in different asset classes.

Currently we have models built to capture risk premia in equities and fixed income. We are still working on ways to capture it in currencies and precious metals/commodities. We have built, bought, and researched several timing models over the years that are based off of technicals, valuations, sentiment, monetary inputs, and any mix of the above. Over time several of these timing models have proven to have a substantial edge over buy and hold especially when it comes to risk control. We have experimented with several different ways to use these models but so far have found that simpler is better and for each bullish model we enter X%. Currently for both fixed income and equities we enter 10% of our position for each model that is bullish using up to 50% of the model portfolio.

Right now we are working on a currency model that takes advantage of the carry trade, but with a risk management filter. We had been struggling to do it in a systematic risk controlled manner but thanks to a post by Macro Man we may have found a solution. If the testing works out we will post an update. As for the Precious Metals/Commodities model portfolio we are working on a CTA technical trend following model. We questioned calling this an Active Beta strategy but after re-reading some research by Bridgewater we decided that with the relative ease (No, it’s not actually easy. But once you have it up and running you shouldn’t have to tweak it much to keep it running.) to maintain it we would include it as Active Beta. Expect more posts on these models in the future as we get further in our research.

Happy Trading,

The Macro Trader

P.S. If you liked this post please add us to your RSS reader. if you have any questions, comments, praises, or criticisms feel free to e-mail us at Editor@TheMacroTrader.com

For further reading on Active Beta and systematic capturing of risk premia, here are some links to go to.
Inside the House of Money Excellent book filled with interviews with leading Global Macro Traders.
Pioneering Portfolio Management Must read book by David Swensen, portfolio manager of the Yale Endowment Fund.
Formula Research Nelson Freeburg builds some of the best systems out there.
World Beta blog Mebane Faber has done a lot of work on systematic methods of reducing risk.
Macro Man blog Macro Man has lots of witty takes on the markets and does quite a bit of solid research.

We received a few e-mails in regards to our last post where we discussed our performance. One of the things that was brought up a few times was why we have self-admittedly taken on too little risk. The simple answer is that we don’t like to lose money. Drawdowns are not something that we enjoy that much.

For a better explanation, let us first explain how we trade. Our basic method of scaling risk is described in the Stanley Druckenmiller interview in The New Market Wizards by Jack Schwager and is further explained in the interview with Christian Siva-Jothy in the book Inside The House Of Money by Steven Drobny. You start out by generating positive returns, and once you are up enough for the year, you can start taking on more risk. For example, if we are up 20%, we don’t mind taking on a risk that could potentially take us down 5%. We’d still be up 15% for the year. On the other hand, if we are only at 0% for the year a -5% hit would be really bad. So basically we trade away with strict loss limits until we are up enough to start raising our risk limits.

We strive to deliver good trading ideas on an absolute and on a risk-adjusted basis. A 50% gain is great, but if you had to risk 100% to get there, then it doesn’t look too good anymore. In that case, being wrong once blows up your account.

You can find more of the same in several other newsletters. For instance, if you pick up a copy of the Hulbert Financial Digest, you can find scores of newsletters that manage to have one 100%+ year and then proceed to lose -87% the next year, -37% the year after that, and so on. Trade like that and you’ll be lucky to have a whopping $10 bucks left in your account.

Happy Trading,

The Macro Trader

Here at The Macro Trader we run five different model portfolios: US equities, fixed income, precious metals, foreign equities, and currencies. We use ETF’s and the occasional Closed End Fund as our trading vehicles.

The starting value of each portfolio was $100,000.00. We typically risk from .5% to 2% (usually 1%) on each position, with each position taking up no more than 25% of the model portfolio’s equity. So for example, with a $100,000.00 portfolio, we would risk no more than $1000.00 from entry to stop on one position, and that one position initially could not take up more than $25,000.00 in equity.

We track each model portfolio against two different benchmarks: The 0-line and the standard benchmarks in their asset class. We use two benchmarks for two reasons: First we believe in absolute returns. Our newsletter is patterned after a Global Macro Hedge Fund, so we pay strict heed to risk controls and positive returns. Who cares if you beat the SP500 because it lost 25% that year, and you “only” lost 20%? Sure, you may have won in Morningstar’s eyes, but you and your investors lost real money. In addition as long as you have positive returns, you could potentially lever up your portfolio to juice up your returns if your trading is sufficiently risk-adverse.

That said, we also track our relative benchmarks because people are used to them and doing so helps us gauge the effectiveness of some of our risk-taking. For instance, if we are taking on a lot of risk and are lagging our relative benchmark, then we need to scale back. If on the other hand we are beating the benchmark while taking far less risk, it may be appropriate to take on a bit more risk. As we will discuss later in this post, the latter situation has been our problem as of late.

US Equities

When we started the letter we had been bearish on US equities for some time. That said, we remained in cash until our 2/1/08 issue when we went short the XLF-Financials ETF. So far we have had three closed out trades. Of the three trades, two were profitable and one was closed at a loss. Our return has thus far been 1.57%. In the same time the SP500 has returned -3.28%. So on an absolute basis we are positive with a 1.57% return and on a relative basis we are beating the SP500 by 4.85%.

Fixed Income

In fixed income our first trade came in the 12/28/07 issue and was a buy of the TIP-TIP’s ETF. Since then we have had six closed out trades and currently have one open position. Of the seven trades all but one has been profitable. Our total return has been 1.9%. In the same time our primary benchmark the TLT-20 Year Treasuries has returned -4.1%. So on an absolute basis we are positive with a 1.9% return, and we are beating our benchmark by 6%. (By the way, as the universe of fixed income ETF’s expands we may change our benchmark to the Lehman Aggregate Index AGG-ETF)

Precious Metals

The first trade we had in precious metals came in the 12/7/07 issue. We went long GLD-Gold ETF. Since that time we have had three total trades in the metals portfolio and all of them have been profitable. Our performance has been good with a 5.23% return which beats the XAU Philly Gold/Silver index by 5.24% and the price of gold by .89%. We were able to achieve this while never being more than 54% invested.

Global Equities

Our first trade was a short in the EWW-Mexico ETF in the 12/1/07 issue. Since then we have had a total of six positions. Four of them have been closed out, and we currently have two open positions. Of our closed trades, three were losses and one was profitable. Currently our two open positions are profitable. Our P/L for this portfolio is -1.33%. That of course comes out to a -$1,326.48 loss. On an absolute basis we are obviously down. Depending on the benchmark used, we are either a bit ahead of a bit behind. Using the EFA-ETF which returned -6.64% we are ahead by 5.31%. Using the EEM-ETF which returned -.09% we are behind by 1.24%.

Currencies

We didn’t have our first currency trade until the 2/22/08 issue. Since then we have had four trades: Three winners and one loser. We are up 3.12%. As of now we are using the DBV-Currency Harvest ETF as our benchmark. Since there is no real benchmark for currencies, we decided to use the carry trading DBV-ETF as a benchmark. The DBV is down -3.71%, so we have beat our benchmark by 6.83%.

Overall the model portfolios are up 2.1% as of today’s close (5/7/08). Of our 20 closed out trades 14 have been winners and six have been losers. Our winners have made $13,894.01 and our losers have lost $3,675.88 for a total gain of $10,218.13. We currently have three open positions, all three are profitable, adding an additional $278.70.

While evaluating our performance, we have realized that we need to take on more risk. With a 70% accuracy rate and a 3.78 profit factor we should probably either be bigger in our positions, have more open positions, or a combination of both. Going forward this will definitely be an area that we will be working on.

Happy Trading,

The Macro Trader

As mentioned in previous posts we run a variety of automatic as well as discretionary trading systems. Running them alongside each other helps us to spot market trends that we might not otherwise see. Well here are a few macro themes that we have found and currently are tracking for good entry points with relatively low risk.

Energy and Raw Materials-Yes, we know that this isn’t exactly a novel idea. But the fact remains that if the world is to continue expanding we are going to need more energy. If more people in third and second world countries are buying cars guess what they need? Yeah you guessed right. They need gasoline and the car companies need steel. If the BRIC’s and friends are to continue growing at their current pace or even half of the current rate then they need raw materials and energy to build. So we are for the most part energy and hard asset (commodity) bulls. While an index probably isn’t a bad way to go we feel that we can get better risk adjusted returns by looking for our own trades and scaling in and out of different securities. So we track a lot of different individual stocks, ETF’s, and commodities.

Housing-We are housing bears. While we don’t see this trend continuing forever or even for ten years we do see it going for at least another year. Does that mean we are shorting everything in housing? No, in fact we currently only have one short position in housing (HOV). But it is a theme we will continue to monitor.

Healthcare-Ultimately the outcome of the health-care industry is probably going to end up with politicians deciding if it is allowed to win or not. For the next 40 years we see several reasons to be long healthcare. Unfortunately we see a reason to be very hesitant. Because of the aging populations in the western world the bulk of the voting population will probably favor government controls on the health system. That being said we still see many potential opportunities in healthcare and bio-tech.

Global Telecom-This is a theme that has been good to us off and on for some time now. We have found that in a lot areas of the world some of the best stocks have been in the telecom industry. Off and on we have been long VIP, MBT, AMX, CHL, SKM, and TKC. In fact last week we re entered TKC. Basically telecom is one of our favorite emerging market industries and whenever a country meets our other criteria it is usually one of the first areas we look at.

These are some of our major trading themes right now. We have other themes we monitor but these should give you an idea as to where we are looking and what we look for. Basically we look for areas that should have long lasting trends and real fundamentals. We then look for entries that present a good risk to reward scenario. We aren’t in the business of risking a dollar to try and make a dollar. We are looking to risk a dollar to make three or four and sometimes even ten.

If you have any questions feel free to contact us here. And if you like what you have read you will want to add us to your RSS reader and consider subscribing to our newsletter.

Happy Trading,
The Macro Trader