Equity investors have long sought ways to participate in the stock market’s long-term gains without bearing the full impact of occasional sell-offs. Copenhagen-based Methodica Capital Partners Fund I takes an unconventional approach to that challenge, combining exposure to the S&P 500 with proprietary FX trading strategies designed to perform when equity market volatility rises. By switching between the two exposures according to its volatility forecasts, the fund aims to retain much of the equity market’s return potential while providing a source of returns during periods of turbulence.

The strategy is the culmination of more than a decade spent developing and refining systematic FX trading models. Andreas Junge, founder, CEO and CIO of Methodica Capital Partners, explains that the idea emerged from analyzing the performance of the firm’s proprietary FX algorithms across different market environments. Junge, a mathematician with more than 25 years of experience in systematic trading, has previously worked in risk management, commodities and freight derivatives, including work with major shipping companies and energy businesses on hedging programmes and systematic trading.

Using FX to Navigate Equity Market Volatility

The strategy is built around an observed relationship between equity market volatility and opportunities in currency markets. “We saw very clearly that our FX strategies have an inverse relationship with equity indices in general, and that their performance is highly dependent on volatility,” Junge explains.

“We saw very clearly that our FX strategies have an inverse relationship with equity indices in general, and that their performance is highly dependent on volatility.”

Andreas Junge, founder, CEO and CIO of Methodica Capital Partners.

The relationship reflects how volatility can spread across asset classes during periods of market stress. Such conditions create more opportunities for the fund’s FX algorithms, which Junge says perform best in moderate-to-high-volatility environments. “When the S&P has a bad day or sells off sharply, we tend to perform pretty well on the FX side,” he explains. “When the S&P has a particularly strong day, our FX strategies tend to perform less well.”

This is what makes FX particularly interesting as a defensive component. “We use FX during periods of high volatility, when the S&P typically comes under pressure, and rely on the strong long-term returns of the S&P when volatility is lower,” Junge explains.

Switching Between Two Distinct Market Exposures

At the center of the approach is an automated allocation protocol that determines whether the portfolio should be predominantly exposed to the S&P 500 or to the FX strategies. The decision is based primarily on the team’s proprietary models, which forecast equity market volatility one day ahead. “If our models predict high volatility for the following day, we switch into FX,” says Junge. “If they predict lower volatility, we switch towards the S&P 500. The switch is made on a one-day basis and is fully automated.”

“If our models predict high volatility for the following day, we switch into FX. If they predict lower volatility, we switch towards the S&P 500. The switch is made on a one-day basis and is fully automated.”

Andreas Junge, founder, CEO and CIO of Methodica Capital Partners.

The portfolio is therefore positioned predominantly in one component at a time, rather than continuously adjusting its weights in response to market movements. Under normal conditions, it may have approximately 85 percent exposure to the S&P 500 and 15 percent to FX. When volatility rises to high levels, those allocations are reversed. “When volatility is increasing to high levels, we are swapping that allocation to 85 percent in FX and 15 percent in the S&P,” Junge explains. 

In particularly calm equity markets, the strategy can also employ modest leverage on its S&P 500 exposure. Over a longer investment horizon, the team expects the portfolio to be invested in equities approximately 65 percent of the time and in FX around 35 percent.

A Diversified Basket of Proprietary FX Algorithms

The FX component currently comprises around 12 individual strategies developed over more than a decade. The models are designed to capture different market behaviors, including momentum, mean reversion and breakouts. “Most of them are statistical, probability-based models,” Junge explains. Some also incorporate information from bond markets, including interest-rate differentials between the United States and Germany, which can influence currency movements such as the euro-dollar exchange rate.

The models also have different return characteristics. Some have relatively high win rates but occasionally experience larger losses, while others are less frequently successful but can generate substantial gains when they are. “Having that mix is quite important for generating returns consistently,” Junge says.

Targeting Equity-Like Returns With Lower Volatility

Junge’s ambition is to outperform the S&P 500 over time, both in absolute and risk-adjusted terms, while maintaining lower volatility. “We aim to beat the S&P, both in absolute returns and on a risk-adjusted basis. We want to deliver a higher Sharpe ratio,” he says. “We also wanted to create a long equity product which has genuine downside protection that actually kicks in exactly when you need it.”

“We also wanted to create a long equity product which has genuine downside protection that actually kicks in exactly when you need it.”

Andreas Junge, founder, CEO and CIO of Methodica Capital Partners.

Junge targets average annual returns of 16-19 percent and volatility of around 10 percent, compared with the 7-10 percent returns he estimates for the S&P 500. He attributes the relatively low volatility target primarily to the reduced allocation to S&P 500 during periods of S&P 500 drawdown. “Our allocation mechanism reduces the volatility relative to S&P 500 since most volatility in S&P 500 arises during drawdowns and these periods are exactly when we are in the FX space,” he says.

Junge acknowledges that the strategy’s ability to provide protection during future market drawdowns still needs to be demonstrated in live trading. “We only started on 19 May, so it is still too early to judge how effective the strategy will be, particularly during significant drawdowns in the S&P.”

The approach is not intended to eliminate equity market risk. Its long-term return potential remains dependent on the S&P 500, and it may lag the index during extended bull markets. “During an extended bull market, we might trail the index by two or three percentage points, while still delivering a positive return. But when the index falls significantly, we would expect the FX allocation to make a substantial positive contribution,” he concludes. “We are still dependent on the S&P for our long-term returns. I would not describe us as a low-volatility hedge fund.”