Leveraging the herd mentality

July 3, 2018 02:30 PM

The reality of life at a quantitative research shop is that our work has less to do with developing algorithms to predict the future and more with finding new ways to use already proven concepts, especially those contrarian ones found in behavioral finance.  

Consider the most widely-known phenomenon of “herding” where investors seek safety, either from potential losses or missed performance, by jumping onto already established trends in the hunt for a “sure thing.” Investing with the herd isn’t necessarily bad, especially if it offers a confirmation signal of an early trend. Trend following is one of the most successful investment strategies, but the results, especially if you are late to the party, can be fatal in the long term.    

Easily recognizable are cases like retail investors piling into technology stocks in the late 1990s creating the Dot.com bubble. Even supposedly sophisticated investors aren’t immune from the herd mentality. Case in point, the recent whipsaw in the U.S. dollar that had steadily weakened throughout 2017 despite clear communications from the Federal Reserve that it was going ahead with monetary tightening. 

Expectations that the Trump administration would push for a weaker dollar combined with profits made by early short sellers in the dollar created an “inverse bubble” such that Reuters pointed out in an April 13 article that traders’ short positions had reached record levels last seen just before the dollar’s big rally in August 2011.                  

The recent pop in the dollar could signal we’re in the early stages of unwinding the dollar-short positions, and with nearly 40 levered and unlevered currency funds representing most of the world’s major economies to choose from, most investors can find an exchange-traded product to play that trade (see “Dollar rebound,” below). But if you’re serious about betting on (or against) the dollar, you might want to look further afield. While these funds can offer nearly perfect correlations to the underlying currency, smaller funds can suffer from high bid/ask spreads and nearly all such funds also carry what have become relatively high fees. Even the largest currency fund, the PowerShares DB US Dollar Bullish Fund (UUP), carries a 0.8% expense ratio and given fairly anemic returns for extended periods; long-term investors can see their returns quickly eaten up by fees.  

Bold investors can take a chance on VelocityShares, which recently launched a series of 4x levered currency funds, but clients using our Quant Screener to rank our coverage universe based on price momentum would see a veritable who’s who of hedged equity funds with 10 names in the top 25 alone—nearly all European or broad international funds.  

First launched in 2011, hedged equity funds are exactly what the name implies, offering exposure to a common international equity benchmark but with futures contracts in place to hedge out any foreign currency risk.  While originally intended for investors looking to add international beta without currency risk, the combination of that risk and equity beta can be remarkably attractive in the right moments.  

Consider the historical returns for the iShares MSCI EAFE ETF (EFA), Xtrackers MSCI EAFE Hedged Equity ETF (DBEF) and the U.S. Dollar Index (see “Hedging currency risk,” left). While the dollar’s gains have been fairly limited so far this year, its strong performance is already helping push dollar-hedged DBEF ahead of EFA while only charging an expense ratio of 0.35%. So why pay PowerShares DB US Dollar Index Bullish Fund ETF (UUP) 0.8% to only gain dollar exposure when you can buy dollar and equity exposure for less than half of that?  

The problem, of course, is trying to gauge not just the potential direction of the dollar but the possible rate of change as its sometimes highly volatile moves can quickly devour any equity gains. The greenback’s weak performance last year ate heavily at DBEF’s returns while European equity weakness in 2014 and 2015 ate at some of the dollar’s returns leaving owners of UUP ahead of the game.  But given that European stocks have ceased underperforming domestic names after years of weakness, now might be the time to consider leaving the dollar bulls behind for a different herd.  

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