Forex Managers and Managed Forex Funds

Many forex managers use a product called a managed forex fund, which is the equivalent to a mutual fund hedge fund. In a “managed forex fund,” the manager will invest the assets under the POA with the forex dealer member in the managed fund. The a trader or traders for the forex dealer member will then manage the pool of assets. Typically the forex dealer member will receive both a forex management fee as well as a performance allocation. Many managers will then charge a management fee and a performance allocation (or only one or the other) to the underlying clients.

Types of Managed Forex Funds
Like mutual funds, a manager can find any number of different managed forex funds or managed forex accounts which are professionally managed by traders, usually at the forex dealer member which executes the trades. Typically these forex funds or accounts will have specific trading strategies developed by the forex dealer member’s proprietary trading team. These strategies can be either traditional fundamental or technical strategies, or they may vary and include multi-strategy forex trading, forex range strateges, forex trend strategies, or specific currency pairs or regions. Please contact us if you would like more information on finding a specific managed forex fund strategy.

Issues with the Managed Forex Fund
One of the biggest issues with the managed forex fund are the fees. In the typical structure a sponsor or manager will in essence white label a program developed by the FDM. The forex sponsor/manager will then charge a fee ontop of what is charged by the FDM. This is in effect a “double fee” to the client and should, in most all situations, be disclosed to the underlying client. Double fees are not inherently bad, but the investor or client needs to understand what is going on.

Another issue with the managed forex fund is that the FDM will typically also make a pip spread on each position and so the FDM has an incentive to trade excessively or “churn” the account. While the FDMs are very aware of this issue and thus conduct the trading so that the is no churning (and no percetion of churning), it is another issue or risk which should be disclosed to the ultimate investor.
All forex managers who used forex managed funds as the central (or part of the) trading stragey (whether through a forex managed account or forex hedge fund) should discuss their trading program and their disclosure document with a forex attorney. All proper disclosures regarding the relationship should be disclosed to the investor.By Hedge Fund Lawyer

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Forex Hedge Funds – Forex Commodity Pools

This is a guide for those managers who want to start a forex hedge fund. It provides information on forex hedge fund structures, an overview of the registration requirements, and a discussion of the process of forming a forex hedge fund. For the purpose of this article we are focusing on spot forex transactions, but much of this information also applies to those managers who trade foreign currency futures and forwards contracts.


Background - Growth of Forex Hedge Funds
While there are no statistics on the number of forex hedge funds or the amount of assets under management, anecdotal evidence suggests a rather large influx of capital into forex hedge funds and certainly managers are deciding to start forex hedge funds in record numbers. It is not hard to understand why. Spot forex has been a popular investment choice for both the retail and instiutional investor who are looking to generate investment returns which do not mirror the stock markets. Many of these managers have been managing their own accounts, prop accounts, or the accounts of their friends and family and now these same managers are starting their own forex hedge funds (also known as forex commodity pools) to bring their strategy to a larger group of investors.

Structural Considerations for Forex Funds
Forex hedge funds or commodity pools are a little bit different than traditional hedge funds because of the extreme liquidity which is a characteristic of the off-exchange foreign currency markets. Because of the liquidity and ease of getting into and out of positions without moving the markets, the structure is typically more flexible and “investor friendly” then other funds.
Specifically, some of the central structural characteristics of forex funds include:

• generally no lock-up (although some managers may have very short lock-ups of 3 or 6 months)
• generally monthly liquidity with notice as short as a week (HFLB note: while many managers would have the ability to allow more frequent redemptions, we do not recommend this practice unless the manager has a good back office which can efficiently handle redemption requests)
• generally monthly performance reporting and some managers even provide more frequent performance reporting
• usually management fees of 1% to 2% and performance fees of 20% or some other sort of “tiered” or “graduated” performance fee structure

Risk Management for Forex Hedge Funds
It is imperative that forex managers have robust risk management procedures. Because of the highly leveraged nature of spot forex transactions, there are unique risks which a manager must be aware of and which the manager must address. Managers will need to discuss their risk management programs with their attorneys. Instiutional investors, especially, will make sure that hedge fund management companies have strict risk management structures in place - this is likely to be a hot topic during the hedge fund due diligence process.

Registration Requirements for Forex Funds
Until this year the CFTC and the NFA had no authority to regulate managers who only traded in the spot forex markets. Congress passed the Farm Bill which provided the CFTC and the NFA with a mandate to register forex managers and associated persons. While final rules have not yet been promulgated, they will likely require all active owners and associated persons to have both a Series 3 exam license and a Series 34 exam license (there may be a grandfathering provision for those persons who were registered as APs prior to the passage of the Farm Bill).

Forex managers will also need to have their disclosure documents approved by the NFA – this requirement will apply to both managers who have separately managed account programs as well as Forex commodity pools. It is also likely that Forex managers will need to institute some sort of NFA compliance program and the manager’s lawyer or compliance firm can help design a Forex compliance program based on the firm’s specific structure.

Timeline
Because of the registration requirements and the disclosure document submission procedures, the time it takes to establish a Forex fund going forward is likely to be at least a couple of months from the date the manager passes the Series 34 exam. Additionally, based on the manager’s situation the timeline may be longer or shorter – the manager’s Forex lawyer or compliance firm will be able to provide more in depth guidance once the facts of the fund have been determined.

Forex Hedge Fund Prices
Like other hedge fund strategies, forex hedge fund pricing will be similar to other types of futures programs. For many managers, the best choice will be to go with a boutique law firm who will be able to draft the Forex offering documents as well as guide the manager though the Forex registration process. Depending on the law firm and the investment program the cost for establishing the Forex hedge fund will be anywhere from $15,000 to $20,000 or more. These costs may or may not include the registration process. If a manager chooses to go with a larger national law firm the costs will likely start at $25,000 or higher.

Offshore Forex Hedge Funds
Because of the worldwide popularity of off-exchange foreign currency trading, there are many Forex managers which are located in offshore jurisdictions and many non-U.S. investors who would like to invest in these programs. Many managers would like to create programs which are available for both U.S. and non-U.S. investors. Depending on the facts of the situation the manager may or may not need to go through the Forex registration process.
By Hedge Fund Lawyer

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Hedge Fund Failures Illuminate Leverage Pitfalls

Leverage is an increasingly popular tool for investors of all sizes. Hedge funds have been at the center of attention when it comes to leverage because a few have failed, leading the media to pay great attention to the drama surrounding such circumstances. Unfortunately though, too little consideration is given to the learning opportunities these failures represent for individual investors.

The fact is the mistakes of others, especially the purported intellectual and social elite of the hedge fund universe, offer wonderful examples of how not to use leverage. With that in mind, let's take a look at leveraged hedge fund strategies and the factors that can and do contribute to their failure.

The Strategies
To begin, consider the following two hedge fund strategies that entail substantial amounts of leverage.

Currency Carry Trade
The currency carry trade strategy is based on the principle of taking advantage of interest rate and currency differentials among the economies of the world. More specifically, it entails borrowing money in a nation (or currency) with low interest rates and investing in a nation (or currency) with high interest rates. On an absolute basis, this type of trade will only result in single-digit rates of return. However, leverage can quickly solve that dilemma.

Interestingly, this is one hedge fund strategy that any individual investor can perform with only a futures trading account. In fact, it is as simple as selling short a futures contract on the low interest rate currency (or borrowing at that rate) and going long a futures contract on the high interest rate currency (or investing at that rate). This is generally what hedge funds do, as futures markets are a very liquid and efficient means to implement this strategy.

Furthermore, given the very low margin requirements for futures contracts, it is easy to apply substantial amounts of leverage. To illustrate, consider the following example of a carry trade through futures contracts that assumes the following:

• The initial outlay is $100.
• $10 purchases $100 in notional carry trade exposure.
• The remaining $90 stays in the money market as margin.
• Cash rates are 4%.
• The embedded cost of capital for the futures contract is 4%. (The embedded cost of capital is a drag on performance of futures contract. For example, if cash rates were 10% for an S&P 500 futures contract and you held the contract until maturity, your return would be the S&P 500's return less 10%.)
• Short (or borrow) in a currency with a 1% yield (i.e., Japanese yen).
• Long (or invest) in a currency with an 8% yield (i.e., New Zealand dollar).
• The investment period is one year.

$100 in Notional Carry Trade Value/$10 in Futures	Percent	Dollars
--	--	--
Interest Paid on Borrowed Currency	-1%	($1.0)
Interest Earned on Invested Currency	8%	$8.0
Gross Positive Carry	7%	$7.0
--	--	--
Embedded Cost of Capital	-4%	($4.0)
Net Positive Carry	3%	$3.0
--	--	--
Remaining $90 in Money Market	--	--
Return	4%	$3.6
--	--	--
Total Return on $100 Cash Investment	6.6%	$6.6

Fixed Income Arbitrage
This hedge fund strategy is a bit more complicated and entails going long and short bonds with varying credit qualities and applying leverage to ratchet up returns. For example, a hedge fund may purchase very high quality corporate or mortgage-backed bonds using leverage. By doing this, they make an incremental returns for each bond purchased with leverage, assuming the cost of the leverage is less than the interest received on those bonds.

Furthermore, because purchasing bonds with leverage entails exposure to both interest rate and credit risk, the hedge fund will also short sell bonds for downside protection. More specifically, they will short bonds of a lower credit quality, assuming they will fall faster in value than high quality bonds if interest rates rise or credit markets deteriorate. This way, they can short fewer bonds than they are long, thereby producing a net positive rate of return, or a "positive carry". If structured properly, this trade creates a steady rate of return with relatively low volatility. This strategy is often referred to as an absolute return strategy.

Although these sorts of trades look great on paper and often work as planned for extended periods of time, they can and do fail. Generally speaking, the risk management side of any levered strategy is based on the historical movements and behaviors of the investment instrument(s) in question. Some risk management models are simple, while others are obscenely complex, but all of them rely on the assumption that past behavior patterns will be repeated within a reasonable degree of error. In the end, however, true risk management boils down to how well unprecedented or unexpected market behavior is predicted.

This is true for both multibillion dollar hedge funds and individual traders with a few thousand in options or futures contracts. Assuming markets behave as expected, levered investments may work out great. However, if markets behave outside of expectations, levered investments tend to break down and experience heavy losses over very short periods of time.

Lessons to Consider
This leads us to the first lesson individual investors need to learn about leverage:

• Lesson No.1: Structure your levered positions to weather unprecedented and unexpected market behavior.
  
  It is inevitable that you will at some point fail to accurately predict the future. Therefore, running into a situation where you experience heavy investment losses on a levered investment is something that needs to be anticipated, regardless of how intelligent you believe yourself (or your advisor) to be. As is the case with hedge funds borrowing from banks or an individual borrowing on margin, margin calls are an undeniable eventuality of using leverage. If you look at the history of hedge funds that have blown up, not including cases of fraud, you will invariably find that all of these failures were a result of an inability to meet margin calls and of being forced out of investments at an inopportune time.
  
  Because hedge funds often tend to be levered at the total fund level, it is rarely the case they have substantial amounts of cash on the sidelines. This is probably the most important lesson to learn about leverage because it is the one thing you can prepare for with complete certainty.

• Lesson No.2: Make sure you have sufficient cash or credit reserves to bail out your levered investment position.
  
  In other words, it's fine to implement levered investment strategies as part of your overall portfolio diversification, but never lever your entire investment portfolio, especially not into a single or concentrated basket of positions.
  
  There are many ways individual investors can introduce leverage into their portfolios, often through brokerage margin accounts or derivatives such as options and futures contracts. Moreover, individual investors can implement some hedge fund strategies such as the carry trade described above. Nonetheless, when doing so investors would be wise to learn from the mistakes of others in this regard.
  
  Typically, hedge funds became too greedy, stretched too far for return and took on too much leverage. This can be the result of overconfidence. This sense of overconfidence is common, as people of all upbringings and educational backgrounds have a tendency to correlate their level of intelligence with the ability to predict the future. Unfortunately, this just isn't how the markets work. In fact, they will almost certainly behave outside of your expectations. As such, failure to accurately predict market behavior is the primary driver of failed levered investments when coupled with a lack of cash on the sidelines

The Bottom Line
The keys to using leverage effectively are very simple:

1. Don't get greedy and reach for returns through too much leverage.
2. Accept the fact you can't predict the future and appropriately model your trades. Also accept this will likely diminish potential returns.
3. Always make sure you have some backup cash or credit on the sidelines in case things go awry.

In the end, the most important thing to realize with leverage is that hawkish monitoring of your investments is essential because short-term market fluctuations can be fatal.

by Eric Petroff,
Eric Petroff is a senior consultant at Hammond Associates. He is a career investment professional and has worked in the industry for more than a decade. Eric received two Bachelor of Arts degrees from DePauw University in Indiana, one in economics and the other in Russian. Thereafter, he attended Webster University in St. Louis to obtain a Master of Business Administration with an emphasis in finance while simultaneously completing the Chartered Financial Analyst (CFA) designation. He is a member of the CFA Institute and the President of the CFA Society of St. Louis for 2007-08.

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Trading the Odds with Arbitrage

"I don't throw darts at a board. I bet on sure things. Read Sun-tzu, The Art of War. Every battle is won before it is ever fought." Many of you might recognize these words spoken by Gordon Gekko in the movie Wall Street. In the movie, Gekko makes a fortune as a pioneer of arbitrage. Unfortunately, such risk-free trading is not available to everyone; however, there are several other forms of arbitrage that can be used to enhance the odds of executing a successful trade. Here we look at the concept of arbitrage, how market makers utilize "true arbitrage," and, finally, how retail investors can take advantage of arbitrage opportunities.

Concepts of Arbitrage
Arbitrage, in its purest form, is defined as the purchase of securities on one market for immediate resale on another market in order to profit from a price discrepancy. This results in immediate risk-free profit.

For example, if a security's price on the NYSE is trading out of sync with its corresponding futures contract on Chicago's exchange, a trader could simultaneously sell (short) the more expensive of the two and buy the other, thus profiting on the difference. This type of arbitrage requires the violation of at least one of these three conditions:

1. The same security must trade at the same price on all markets.
2. Two securities with identical cash flows must trade at the same price.
3. A security with a known price in the future (via a futures contract) must trade today at that price discounted by the risk-free rate.

Arbitrage, however, can take other forms. Risk arbitrage (or statistical arbitrage) is the second form of arbitrage that we will discuss. Unlike pure arbitrage, risk arbitrage entails--you guessed it--risk. Although considered "speculation," risk arbitrage has become one of the most popular (and retail-trader friendly) forms of arbitrage.

Here's how it works: let's say Company A is currently trading at $10/share. Company B, which wants to acquire Company A, decides to place a takeover bid on Company A for $15/share. This means that all of Company A's shares are now worth $15/share, but are trading at only $10/share. Let's say the early trades (typically not retail trades) bid it up to $14/share. Now, there is still a $1/share difference--an opportunity for risk arbitrage. So, where's the risk? Well, the acquisition could fall through, in which case the shares would be worth only the original $10/share. Further below we will take a look at how you can gauge risk.

Market Makers: True Arbitrage
Market makers have several advantages over retail traders:
• Far more trading capital
• Generally more skill
• Up-to-the-second news
• Faster computers
• More complex software
• Access to the dealing desk
• And more

Combined, these factors make it nearly impossible for a retail trader to take advantage of pure arbitrage opportunities. Market makers use complex software that is run on top-of-the-line computers to locate such opportunities constantly. Once found, the differential is typically negligible, and requires a vast amount of capital in order to profit--retail traders would likely get burned by commission costs. Needless to say, it is almost impossible for retail traders to compete in the risk-free genre of arbitrage.

Retail Traders: Risk Arbitrage
Despite the disadvantages in pure arbitrage, risk arbitrage is still accessible to most retail traders. Although this type of arbitrage requires taking on some risk, it is generally considered "playing the odds." Here we will examine some of the most common forms of arbitrage available to retail traders.

Risk Arbitrage: Takeover and Merger Arbitrage
The example of risk arbitrage we saw above demonstrates takeover and merger arbitrage, and it is probably the most common type of arbitrage. It typically involves locating an undervalued company that has been targeted by another company for a takeover bid. This bid would bring the company to its true, or intrinsic, value. If the merger goes through successfully, all those who took advantage of the opportunity will profit handsomely; however, if the merger falls through, the price may drop.

The key to success in this type of arbitrage is speed; traders who utilize this method usually trade on Level II and have access to streaming market news. The second something is announced, they try to get in on the action before anyone else.

Risk Evaluation
Let's say you aren't among the first in, however. How do you know if it is still a good deal? Well, one way is to use Benjamin Graham's risk-arbitrage formula to determine optimal risk/reward. His equations state the following:

Annual Return= CG-L(100%-C)/YP

Where:
• C is the expected chance of success (%).
• P is the current price of the security.
• L is the expected loss in the event of a failure (usually original price).
• Y is the expected holding time in years (usually the time until the merger takes place).
• G is the expected gain in the event of a success (usually takeover price).

Granted, this is highly empirical, but it will give you an idea of what to expect before you get into a merger arbitrage situation.

Risk Arbitrage: Liquidation Arbitrage
This is the type of arbitrage Gordon Gekko employed when he bought and sold off companies. Liquidation arbitrage involves estimating the value of the company's liquidation assets. For example, say Company A has a book (liquidation) value of $10/share and is currently trading at $7/share. If the company decides to liquidate, it presents an opportunity for arbitrage. In Gekko's case, he took over companies that he felt would provide a profit if he broke them apart and sold them--a practice employed in reality by larger institutions.

Valuation
A version of Benjamin Graham's risk arbitrage formula used for takeover and merger arbitrage can be employed here. Simply replace the takeover price with the liquidation price, and holding time with the amount of time before liquidation.

Risk Arbitrage: Pairs Trading
Pairs trading (also known as relative-value arbitrage) is far less common than the two forms discussed above. This form of arbitrage relies on a strong correlation between two related or unrelated securities. It is primarily used during sideways markets as a way to profit.

Here's how it works. First, you must find "pairs." Typically, high-probability pairs are big stocks in the same industry with similar long-term trading histories. Look for a high percent correlation. Then, you wait for a divergence in the pairs between 5-7% divergence that lasts for an extended period of time (2-3 days). Finally, you can go long and/or short on the two securities based on the comparison of their pricing. Then, just wait until the prices come back together.

One example of securities that would be used in a pairs trade is GM and Ford. These two companies have a 94% correlation. You can simply plot these two securities and wait for a significant divergence; then chances are these two prices will eventually return to a higher correlation, offering opportunity in which profit can be attained.

Find Opportunity
Many of you may be wondering where you can find these accessible arbitrage opportunities. The fact is much of the information can be attained with tools that are available to everyone. Brokers typically provide newswire services that allow you to view news the second it comes out. Level II trading is also an option for individual traders and can give you an edge. Finally, screening software can help you locate undervalued securities (that have appropriate price/book ratio, PEG ratio, etc.).

There are also several paid services that locate these arbitrage opportunities for you. Such services are especially useful for pairs trading, which can involve more effort to find correlations between securities. Usually, these services will provide you with a daily or weekly spreadsheet outlining opportunities that you can utilize to profit.

Conclusion
Arbitrage is a very broad form of trading that encompasses many strategies; however, they all seek to take advantage of increased chances of success. Although the risk-free forms of pure arbitrage are typically unavailable to retail traders, there are several high-probability forms of risk arbitrage that offer retail traders many opportunities to profit.

by Justin Kuepper,
Justin Kuepper has many years of experience in the market as an active trader and a personal retirement accounts manager. He spent a few years independently building and managing financial portals before obtaining his current position with Accelerized New Media, owner of SECFilings.com, ExecutiveDisclosure.com and other popular financial portals. Kuepper continues to write on a freelance basis, covering both finance and technology topics.

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