Eleuthera Capital

Originally published in the October/November 2011 issue

Philippe Bonnefoy, the founder of Eleuthera Capital, is trying to exploit one of the biggest anomalies in portfolio investing. It concerns the currency market and the fact that few investors have any significant exposure to it except by virtue of other assets they own.

What makes this odd is that the global currencies are a multi-trillion dollar daily market. It is by a wide margin the biggest, most liquid asset class traded globally. Typically corporate treasurers have sought to hedge currency risk using various swaps or futures. For investors, however, there has been a glaring absence of managers with products able to generate returns from this hive of market activity. What’s more, with correlations between equities the highest they have ever been, investors are very keen to diversify the risk/return profiles in their portfolios.

Bonnefoy, a veteran macro manager who founded Cedar Partners Investment Management, is now proposing to do just this. It is a solution that should be of interest across the investment landscape – from private investors to pension funds and endowments – as should its annual target return of 15-25%.

“In looking at the various asset classes, the one that was bizarrely underrepresented in people’s portfolio was currency trading,” Bonnefoy says. “It is a $4 trillion a day market. Yet there is only $9 billion of dedicated funds trading currencies, although obviously there is much more in overlay products. Having spent four years designing the systems for the Eleuthera Currency Fund means that the heavy lifting has been done.”

Systematic strategy
The fund is meant to address the fact that most currency funds offer an investment return generated by carry. This is generally obtained by borrowing in currencies with low interest rates and investing in ones with higher interest rates. But the current market environment means that in a sudden switch to risk off, a fund can loose its cumulative carry for the year.

Bonnefoy and co-founder Riadh Fessi looked to develop a fully systematic strategy to make an absolute return from short-term currency trading. The goal was to design a product that could make money when there was no market trend and, indeed, get away from interest rate conditions or long-term trends being the source of return.

To do this the pair developed a short-term directional model and a mean reversion model that work in tandem. The approach should do well in times of high volatility because trading ranges expand outwards. During periods when trading ranges narrow, there is less currency volatility to capture and returns would be expected to contract.

“In the recent 15-month incubation test trading period, it has been pretty much optimal conditions for us,” says Bonnefoy. “We love currency volatility and there has been a lot of it and we expect those conditions to continue for the next few years.”

Indeed, recent news reads like a roll call of events for a currency fund. Central bank interventions have been on the increase. US government bonds had their credit rating cut, while markets have oscillated between risk on/risk off at a feverous pitch. On top of this is the trading of the euro amid policy deals one day and changes of tack, sometimes outright reversals, just days later.

Volatility drives returns
The heightened market risk from this backdrop provides the volatility conditions that Bonnefoy wants to harness to engineer returns. But it also, of course, cranks up the risk to investors’ capital. The chief way the fund looks to curtail this is by limiting trading to just the eight biggest liquid currency pairs and using a fully systematic trading process (See Fig. 1).

EleutheraChart1a“What’s nice is that the strategy is super efficient in how it trades,” Bonnefoy says, citing low slippage. He also notes that the growth of ultra high frequency traders has boosted price competition and helped to narrow bid/offer spreads. There is a knock on positive impact on counterparty risk as currency trading is increasingly based on a larger number of smaller transactions with less risk than one processing fewer, very sizeable trades.

The vast majority of FX business is a commercial activity conducted by corporate treasurers and hedgers, helped along by speculators. Inefficient price action is reflected in a currency moving one way, then reversing before retracing as reactions feed through to a piece of data or the utterance of a policy maker.

Eleuthera is primarily looking at market price action. Using decades of experience Bonnefoy and Fessi have created a model that slices up intraday periods of time. The model looks at price action with reference to recent volatility and trading ranges or similar price action in previous time periods, and then aims to capture part of the expected move.

“I find it interesting that the correlation between the different currencies which you would think would be there doesn’t often exist,” says Bonnefoy. “It can be expressed differently in different time periods. Volatility can be expressed either in directional risk on/risk off terms like the VIX, or within the currency market itself between currency pairs.”

The fund looks at price action through a number of filters and looking for high probability set-ups. Among its numerous screening factors are: bought-oversold; directional analysis; momentum; volatility analysis and pattern recognition. The aim is to receive multiple confirmations, through numerous variables, that the market is approaching an inflection point and the models will deliver alpha when the market begins to move, through either a new direction or a mean reversion. A return target is set depending on the size of the expected move and when the target is hit a profit is booked on the trade and the managers move on to look for another opportunity. The average trade duration is typically within the day.

“We are trying to be fairly unambitious with our return targets per trade, Bonnefoy says. “We want frequent accrual-like profits that generate consistent steady returns. In both our back-testing and our live trading about 80% of our trades are profitable. As you begin to go into longer time frames you are taking a more directional risk. What we are trying to do is take some alpha out of the noiseof trading. As you begin leaving the noise and take a more systemic move you are becoming more of a trend trader in some form or another. What we are trying to say is that within that noise there is a good opportunity to try and capture some returns.”

The Eleuthera Currency Fund is now available via a Cayman master-feeder structure. It is also expected to be launched in January in an Irish UCITS format being run by Newscape Capital Group where Bonnefoy is chief investment officer and chairman.