Former star sell-side currency strategist Stephen Jen confesses that he always had intentions to run his own hedge fund and currency overlay programmes, and began planning the venture with partner Fatih Yilmaz eight years ago. “The buy side always fascinated me as it involved particular aspects: risk-taking, employing capital, processing information, and getting the call right”. For Jen this was the logical progression from an investment banking career where he spent 13 years at Morgan Stanley famously making bold and timely recommendations – and became especially renowned for his bearish calls ahead of crises. The sell-side phase culminated in him being head of global currency research, “interacting with the big figures in the macro space”, by which he means senior policymakers.
Policy is paramount
“The Federal Reserve is first and foremost” amongst Jen’s policy contacts. The US Treasury was less important last year although it has been pivotal in the past for the Asian currency policies that Jen follows closely. More recently Jen has been developing a dialogue with senior Japanese officials, as well as reconnecting with those in China and other emerging markets with whom he has spoken for many years. “Policymakers do not dictate trends 100% but they play an important role in shaping where asset prices go,” he points out. Jen explains how he visualises market action as being driven by three pillars: (i) macro fundamentals, (ii) market positioning and momentum, and (iii) policies. “Five years ago the first pillar – the fundamentals – mattered the most, but now policies have so many more dimensions and go much further than before, in all countries, not just the US,” is how he sees the context today. Right now Jen has noticed a sharp divergence opening up between Federal Reserve and European Central Bank Policy – and thinks some triangulation is needed to grasp the repercussions of this. “It creates a very rare environment where the two biggest central banks are going in opposite directions,” he surmises.
These policy agendas feed into the fund’s trade ideas. Currently, one core theme is owning the US dollar, partly because “the US is an oasis of growth,” he says. Valuation differentials are also important: “Economists might disagree on the extent of undervaluation, but it’s not overvalued as tourists find the US cheap,” he explains, and adds that relative unit labour costs in the US are the most competitive in 30 years. What Jen finds really striking is that the cumulative gap between US and Canadian unit labour costs actually dwarfs the gap between German and Spanish unit labour costs. And, crucially, the US and Canada still have room to manoeuvre currencies whereas Germany and Spain are in the straitjacket of currency union.
Jen sees a sea change in market dynamics in 2013, and indeed nearly all of the 15.5% returns he has generated since inception in November 2011 have come this year. He admits that 2012 was not the best climate for macro trading due to a lack of differentiation and trends. For several years almost all asset classes had been rising in a synchronised way, whether they were traditionally high beta assets like the Australian dollar or low beta such as the Swiss franc. When the Fed started talking about tapering, both bonds and equities sold off together – and Jen thinks this may mark the start of a larger shift. If the Fed eventually normalises interest rates, he thinks bonds could sell off a lot further – and Jen believes that the Fed is serious about tapering sooner rather than later, even if it is also committed to raising the federal funds rate (FFR) later rather than sooner.
Short euro and emerging markets
Jen thinks that Draghi’s apparent willingness to maintain accommodative policies is partly down to Europe’s broad-based and deep-rooted problems, which Jen enumerates as “structural, logistical, institutional and political”. These many issues may or may not translate into trading opportunities, but Jen does think the euro/dollar exchange rate should go lower, “as Dragi has made it clear that the ECB policy path will be very different from that of the Federal Reserve”. Jen’s intermediate target for the euro/dollar exchange rate is 1.20, and he thinks it could fall further.
Jen has also been characteristically early in turning sour on emerging markets where he sees “legacy problems from excess reserve holdings arising from massive amounts of capital inflows”. Jen’s calculations suggest that cumulative inflows over the past nine years have mounted up to as much as $7.7 trillion, an unprecedented amount, and cautions that “exit doors are the same size as 10 years ago”. Jen ominously observes that the volumes of redemptions seen so far are tiny versus the size of the inflows – and his conclusion is a warning that “a sudden stop event could be very violent”.
Moving onto specific emerging countries, Jen thinks that “China is wealthy enough to pacify the situation”, if its non-performing loans explode in size – but then other countries “do not have the resources and reserves to deal with a faltering China”. He hints that these could include the Brazilian real, which was overvalued, and thinks both India and Indonesia will likely weaken. These countries are “not resilient to handle a bear scenario” in his view. Jen thinks emerging currencies could suffer from other angles and envisages bearish scenarios that are consistent with China avoiding a hard landing. He argues that “China doesn’t even have to break” for emerging currencies to suffer. Instead of being pushed down by a faltering China, emerging markets face pull pressures from the US, and could simply see “so much money sucked back by a recovering US”. Jen draws parallels with the 1980s Latin American crisis, which was triggered by Fed rate rises – and also thinks the 1990s dollar strengthening since 1995 is analogous. This year he sees scope for both rising rates and a strengthening dollar to be a double whammy for emerging currencies.
While some participants are already shocked to read about the Indian rupee making fresh all-time lows this year, for Jen, “It’s not over; it’s only the second innings of this process.” He thinks emerging currencies could soon be confronted with negative carry and volatility, which might even accelerate the downwards momentum. One recent research piece was alarmingly entitled “the pre-quake tremors of emerging currencies”. However, Jen is not yet confident enough on timing to have a big position before the process starts – he wants to wait for some good moves before adding to bearish emerging markets positions.
Reflecting on his years at Morgan Stanley, Jen recalls that he was “quite outstanding as a strategist” during crises, and made the right calls in crises, with 1997 and 2008 the most memorable years. During the 1990s Asian crisis, in particular, he made some really good calls. “But I cannot recall brilliant calls in peace time,” he says, suggesting he is not sure if he will perform so well in a normal environment – after the 1997 Asian crisis Jen admits that he did not get the recovery call right. Most recently in 2008-2009, however, he got both the crisis and the recovery calls right: turning 100% bearish on emerging currencies in mid-2008 before reversing to a constructive stance in early 2009. The early 2009 positioning, short USD and long emerging markets, is the opposite of his current stance, where he is “trying to pick the top”. How far emerging currencies might fall will depend on a range of factors – sentiment, fundamentals and policy reaction to the sell-off will all play some role. “Exchange rates always overshoot and undershoot, so there will also be a time to buy emerging currencies back, when their prices fully reflect the bad scenarios,” says Jen of his game plan.
This fund is not afraid to make strong directional calls and predominantly pursues the traditional old-school macro approach. Cross-sectional or relative value trades that might somewhat dilute core views are rarely done. “The fund is top-down and discretionary, with trends, policies and dynamics driving trades,” says Jen. In summary, SLJ trades on fundamentals: “We watch the technical, but do not trade on technical,” he says, and thinks over-trading is often counterproductive.
Dual managers and quant models
Both Jen and co-manager Fatih Yilmaz hold PhDs in Economics, and their skill sets are very complementary. The latter, who headed up institutional quantitative research at Bank of America, as well as being head of currency strategy there, “is super-strong at quant and has what I don’t have – experience in building quant models,” says Jen. Their geographic specialities also dovetail well together – Jen has a deeper knowledge of Asia partly from his early days at the IMF in Washington DC, while Yilmaz has watched the Middle East and Latin America more closely. The two of them have always stayed in touch and always shared macro ideas in a very intuitive way. “The fund is co-managed,” says Jen, so if one of them is a bull and the other a bear they may refrain from trading a particular market. When the duo are in agreement after bouncing ideas off each other, there is potential to put on higher-conviction positions.
SLJ’s multi-factor quantitative models are just one input into their overall discretionary process – “nobody follows the models mechanically,” Jen says, although SLJ’s fundamentally based models have performed better than pure price momentum-based models, “where policy interventions disrupted momentum,” and the SLJ models also trumped carry trade models, based purely on interest rate differences, which have not done well with so little carry remaining. The SLJ approach is more eclectic: signals monitored include yield curve shape and how that reflects expectations, which gets plugged into a systematic process, as do prints for industrial production and consumer sentiment.
While currencies are the main asset class, some other macro assets are also traded: bonds, equity indices, commodity indices and some single commodities with the offshore Cayman fund doing more in the non-currency space than the UCITS. Jen’s first step into the buy side was at energy hedge fund Bluegold, where he was MD of macroeconomics and currencies, profitably running his own book and gaining insights into the oil markets. This year SLJ has profited from the recoupling of two benchmark oil contracts: West Texas Intermediate and Brent Crude. The price spread between the two briefly blew out as wide as $25, and is now back down to $1.0. SLJ has captured about 70% of the re-convergence, which was aided by new links in the supply chain: special rail lines now allow the US to export WTI via pipelines to ports. What made this trade really special was the diversification benefit it added to the portfolio. “The spread is totally uncorrelated with Fed policy or global demand, which would affect both types of oil – not just one,” he says. This was that rare beast, a trade genuinely uncorrelated to other macro trades at a time when traditional diversification tools – such as owning bonds to hedge equities – have not worked.
So, portfolio diversification is one aspect of risk management, which is a delicate balancing act. “A good risk policy should stop you out when you are wrong – but not when spurious price moves occur that don’t change your fundamental view,” he elucidates, and admits that striking this balance is often a judgement call – although mechanical limits also apply with stop losses and maximum drawdown levels. Positions are sized in part according to their volatility – with more volatile markets sized smaller to reduce the risk of being stopped out just due to random and meaningless “noise”. The risk management approach blends preventative or “ex ante” constraints like exposure ceilings or Value at Risk projections, with corrective or “ex post” limits such as stop losses at the position level and a hard drawdown limit for the fund.
Value at Risk for the UCITS has remained well beneath the one day, 99% confidence cap of 20% based on a four-year look-back. Liquidity is not a problem – Jen argues that the foreign exchange market has “retained healthy liquidity all round”, although careful attention does need to be paid to time-zone issues to maximise pockets of liquidity. The strategy mainly invests in G10 currencies but can allocate between 20% and 50% to emerging currencies. The reason why SLJ stays away from smaller currencies is not liquidity – but rather that they do not fit the top-down approach that seeks to identify the dominant macro themes. SLJ are also explicit in saying that the strategy is not designed to extract liquidity premiums.
The MS SLJ Macro UCITS Fund is a sub-fund of the FundLogic Alternatives plc, Irish-domiciled OEIC. Morgan Stanley has been appointed as the promoter, risk manager and distributor for the daily dealing UCITS fund, marketing the product across multiple European jurisdictions. Morgan Stanley handles relations with the local regulator, the Central Bank of Ireland, and is also responsible for ensuring that the fund is compliant with UCITS regulations. Northern Trust Fiduciary Services is the custodian, and trustee, while Northern Trust International Fund Administration Services (Ireland) Limited is the transfer agent, administrator and money laundering reporting officer. For these accounting and other activities SLJ benefits from its distinguished parentage. Organisationally SLJ is part of the TCI (The Children’s Investment Fund) family of funds, being partly owned by TCI, which provides the middle and back-office platforms, freeing up the risk-takers to spend all of their time on investment matters.
Jen’s macro views can also be accessed in other ways. He continues to sell his research reports on a standalone basis for those investors who prefer to make their own trading decisions. Making advisory research available to everyone, including competitors, illustrates how SLJ’s open culture contrasts with the secrecy of some hedge funds. “Nobody should be surprised by the portfolio,” he says, and summarises the approach by saying, “Writing and thinking constantly instead of trading is the right way to identify the right trends.”
Additionally active currency overlay mandates are offered – these tend to have much lower volatility targets and trade less frequently than the funds. The overlay mandates, typically offered to pension funds, endowments and foundations, employ the concept of “portable alpha” by tailoring return targets to customised benchmarks based on the client’s liability profile. Only Jen’s multi-month views go into the overlays, which avoid the “wiggles” of trading seen in the funds.
Whichever avenue investors choose for getting exposure to Jen’s views, they can rest assured that this is one manager who will be prepared rather than shocked by the prospect of another crisis.