London-based ETF issuer First Trust Global Portfolios is to launch the First Trust FactorFX UCITS ETF (FTFX), an actively managed exchange-traded fund investing in foreign exchange markets.
FTFX will typically hold between 20 and 30 currency pairs across both developed and emerging markets.
Scheduled to be listed on the London Stock Exchange on 1 August 2017, the ETF will hold between 20 and 30 currency pairs across both developed and emerging markets.
Research shows that while exchange rates are largely driven by fundamental factors, significant short-term deviations can occur leading to the potential for capturing positive alpha. These deviations result from the presence of participants (including central banks and international goods traders) that trade currencies without explicitly seeking profit within foreign exchange markets themselves.
The ETF will primarily seek to earn alpha through the implementation of various carry trades, which are strategies that seek to capitalise on the interest rate differential between various currencies. It is typically administered by selling short a low yielding currency and using the proceeds to invest in higher yielding currencies, thereby earning a positive interest rate differential.
While carry trades have the potential to earn reasonable premia over a long time frame, they are not without risk. The strategy can unwind quickly when volatility in the underlying currency spikes, leading to potential losses. Therefore an active approach to a carry trade strategy is favoured over a purely passive index-based approach for the ability to select currency pairs with appropriate levels of volatility risk.
To refine the fund’s carry trade strategy, First Trust will analyse the currency pairs across value and momentum characteristics, two factors with well-established influence in the foreign exchange market.
Value analysis involves investigating whether a currency is potentially undervalued or overvalued relative to some fundamental measure such as real interest rate equilibrium, relative purchasing power parity or differences in current account levels.
Momentum analysis involves investigating the past price data of currencies with First Trust giving each currency a composite momentum score based on its total return performance across short-, medium- and long-term horizons. According to First Trust, this process offers a broader, more robust analysis of a currency’s momentum compared to single measure methodologies such as evaluating support or resistance levels.
The ETF will invest in forward foreign exchange contracts, futures, money market instruments and short-dated sovereign debt denominated in local currencies. It will be managed by members of the investment team at First Trust Global Portfolios, Leonardo Da Costa, a portfolio manager at First Trust and fixed income and emerging specialist and Anthony Beevers, a portfolio manager and quantitative strategies specialist.
The fund may serve as a satellite holding within an investor’s overall portfolio to increase diversification and enhance income.
It has a total expense ratio (TER) of 0.75%.
To gauge performance, the fund will be benchmarked against the JP Morgan G10 FX Carry Strategy Index. Based on a universe of G-10 currencies, this index strategy goes long the three currencies (versus the dollar) with the highest short-term interest rates and shorts the three currencies (versus the dollar) with the lowest short-term interest rates.