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

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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.

As you probably know Macro-Traders typically take a top-down approach when looking for potential investment ideas. Specifically we look for the best risk to reward opportunities we can across all asset classes, countries, and trading strategies. So we basically trade anything anywhere that we can find an edge.

Our investment approach takes a multi-step process to generate investments for our portfolios.

This is a flowchart showing our basic process.

 

What follows is an explanation of each step.

 

We have two ways to come up with investment ideas. We have our quantitative methods and our traditional research. Our quantitative methods vary from all out trading models that give actual buy and sell signals to scanners that look for favorable conditions in different asset classes, to a few tools we have that just look for unusual activity. One of the best things about using quantitative tools is that we miss fewer opportunities due to a computer being able to scan more asset classes in more markets than we could ever do.

As much as technology helps us to catch things we wouldn’t otherwise find. We also rely heavily on traditional research. We are always reading magazines, newspapers, books, trade publications, research reports, etc. We read anything that might help us find new investment opportunities or more information for our current positions and themes. We also try to listen to smart people and watch news and other television that might help us find anything helpful. Basically we are information junkies.

Our next step after getting some investment ideas is to research them further to validate them. Most of the time we hit dead ends, but occasionally we come across something good. If we decide that it makes sense we start looking to see if there is a past model that goes with it. For instance as of this writing we are bullish emerging market telecom and have been for some time. When we first came across this theme we liked the idea because it was logical. So looking for a model we found VIP and MBT both Russian telecoms. They both had outstanding growth rates and the stocks were definitely outperforming the market. Well since then we have traded them and have found several other good telecoms riding that theme like TKC, TMX, TEF, and ETF.

After deciding that what we have found is a solid theme that works out fundamentally, we look at the risks and rewards. Risk management is the most important part of what we do. We look at risk on several levels. At the individual security level we look to see what the best instrument to trade is. For instance if we are bullish on a country do we play it using equities, debt, or currency? We then look to see if we can cut off risk by using options. We like options for their flexibility. Many times we will find an idea that we like but due to the risk profile we can’t get in using the typical security, but we are able to manage the risk by using options. Another risk we really look at is portfolio risk. How does it correlate to our other positions, how does it correlate to the overall portfolio, are we actually just playing another version of a theme we already have on? We look at geographic, political, and any other type of risk we can. The final thing we look at is at what point do we admit that we are wrong? Or in other words where do we place our stop. Our stops are based off of the chart, volatility, potential reward, and size of our position. With risk there are not too many absolute rules. But one that we do always abide by is to never risk more than 2% of the portfolio on any position. Many times we will risk less but we will never risk more. So we size our positions accordingly.

Once all of this has been done we can finally add it to our portfolio. In future posts we will go into more depth on each part of this process. But this should give you an idea as to what we do and how we go about doing it.

Happy Trading,
The Macro Trader

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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

As we have previously mentioned we run a Global Stock Model that essentially tries to be in the best countries. While we often trade ADR’s and have traded open ended mutual funds for the most part we trade the ETF’s. Occasionally that is not possible so if we can find a Closed End Fund that is correlated to the country index we will use that instead.

We keep a watch list of countries meeting our Stock and Interest Rate criteria and if they reach our entry prices we will buy them. We typically will only enter the top 5 on our list but depending on the geographic location of the countries, the macro-environment, valuation, and several other criteria we will buy other ones instead of or as well as the top 5. For a better idea of what goes into individual country criteria read this post on Singapore EWS.

We will go over our actual entries in greater depth in later posts. But essentially we look to buy in solid up-trends using breakouts and pullbacks. We are also addicted to risk management. If we can’t find a low risk entry we will wait. In our Newsletter we provide specific entries, exits, and stops for all of our positions. We don’t adhere to any profit target method but instead move our stops up as a position moves in our favor. We find this allows us to ride trends past where we “think” they should end while still using good risk management. As noted earlier we will cover a lot of this in later posts and cover it all in our Newsletter.

Back to the subject title here in order of geographic regions is our Long Global ETF/Closed End Fund watch list.

EWU-Great Britain ETF

EWQ- France ETF

EWG-Germany ETF

EWP-Spain ETF

EWL-Switzerland ETF

EWN-Netherlands ETF

VGK-Europe ETF