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This Hedge Fund Topped Rivals With Mix of Algorithms and 16th-Century Theory

  • First Quadrant-run fund jumps 9.6% in past year, beating peers
  • Firm model is inspired by concept of purchasing power parity

The market turbulence leading investors to flee hedge funds around the world is providing a measure of vindication for one asset manager.

First Quadrant LP, which manages $11 billion in foreign-exchange strategies, relies on computer models that crunch data such as interest-rate differentials and equity valuations to identify currencies’ fair value and determine entry and exit points. The $1 billion Absolute Return Currency Fund it runs out of Pasadena, California, for John Hancock Investments has returned 9.6 percent in the past year, topping 13 rivals tracked by Bloomberg.

The success marks a turnaround from 13 months ago, when the fund logged its steepest daily drop on record after the Swiss National Bank’s shock decision to abandon the franc’s cap against the euro. First Quadrant’s fair-value model benefits from the current environment of risk aversion and heightened volatility. It’s based on a theory with roots in Renaissance Spain that asserts currencies will eventually adjust so their purchasing power equalizes. The yen, about 20 percent undervalued according to Deutsche Bank AG analysis, has climbed 5.6 percent against the dollar in 2016 amid concern global growth is stalling.

“In terms of periods of time when fair value works the best, at least our version of it, is in times of stress,” said Jeppe Ladekarl, who manages the Absolute Return Currency Fund with Dori Levanoni. “In this particular period of time we have had markets that traded quite well along the lines of fair value. The yen is one of them.”

The fund has been betting on the dollar, euro and yen against a basket of equally weighted currencies. The three have all gained versus their other major peers this year, according to data compiled by Bloomberg.

A First Quadrant fund that uses a similar model and allows higher levels of volatility has gained 14 percent in 2016, according to a Citigroup Inc. platform that tracks the performance of currency-focused hedge funds.

The Absolute Return Currency Fund plunged 8.7 percent on Jan. 15, 2015, after bets the franc would weaken backfired. The currency was already overvalued by 44 percent at the time, according to Organisation for Economic Co‑operation and Development measures.

It was the biggest daily drop since the fund’s founding in 2010. It was also the largest decline that day among more than 2,000 U.S.-domiciled funds tracked by Bloomberg with at least $1 billion under management at the time.

After muddling through the rest of 2015, the money manager’s fair-value strategy began to pay off this year as concern over a global demand slump and policy makers’ response to slowing growth worldwide drove investors to currencies anchored by positive trade flows. Japan and the euro area have among the world’s biggest current-account surpluses.

The strategy is based on the theory of purchasing-power parity, an achievement of theologians at the School of Salamanca, where it was developed based on silver and gold trading between Spain and its colonies in the Americas during the 16th century.

“All the funds that are hot right now are having unusually good streaks because of what’s going on in the world right now, which is a risk-off environment,” said John Dean, managing director of London-based Absolute Return Strategies Ltd., which selects hedge-fund strategies for its investible indexes. “But foreign exchange changes its characteristics really quite rapidly. Risk-off is a one-in-five-year phenomenon.”

The Absolute Return Currency Fund lost money in 2015 after generating positive returns in four of the previous five years when including dividends.

Systematic Funds

First Quadrant is also riding rising demand for systematic funds. More than two-thirds of hedge-fund investors use systematic strategies, with investment consultants and pension funds driving demand, a Deutsche Bank investor survey conducted in February showed.

Unlike the traditional discretionary style of trading that leans on fund managers’ intuition and insight, systematic funds don’t take directional views and let the computer models do the work.

In First Quadrant’s framework, polarizing opinions on some of the most important questions in markets, such as oil’s outlook, U.S. recession risks and a Chinese hard landing, show big moves in currencies are ahead as investors await fresh evidence that’ll reveal the state of the world economy.

“In an environment when currencies have started moving and you have a pickup in volatility, you have more chance for foreign exchange to realign to their fair value,” said Saeed Amen, a cross-asset strategist at Thalesians Ltd., which specializes in quantitative finance. “Foreign-exchange fair value strategies like purchasing power parity, they tend to work in specific times. It’s not going to be the case for strategies like that to work continuously over a long time.”