THE PRICE IS RIGHT
by Christopher Cruden, Managing Director, Insch Capital, Lugano
On 17th January this year, two days after the
Swiss National Bank had shocked the global foreign exchange markets by abandoning
its self-imposed cap on the Swiss franc’s rate vs the euro, the
long-established Florida-based hedge fund manager Everest Capital announced
that, as a result of losses sustained in the currency turmoil, it was to close
its $830m flagship Global Fund. A little
more than a month later, according to a Reuters
report, Everest’s head, Marco Dimitrijevic, sent a letter to investors
announcing the further closure of six of the firm’s seven remaining funds which
had started the year with combined assets of over $2 billion.
Everest was by no means the only casualty of the SNB’s
decision. Many investment firms were
positioned, as market-speak has it, on the wrong side of the trade, a bad place
to be on a day which saw the value of one Swiss franc rise some 20% against the
euro (with an intraday spike of more than double that) and near catastrophic if
positions were highly geared or leveraged as is frequently the case in the FX
business. (As one of Britain’s senior
hedge fund managers once commented, “You’ll always make money if you use
leverage ... provided you don’t go broke first”).
Shocks of this magnitude are fortunately uncommon in global
FX but they are not unknown: financier George Soros’s $1bn move on 16th
September 1992 to smash the pound out of ‘Exchange Rate Mechanism’ is a case in
point. For the most part, however, the
markets trend rather than spike, are highly liquid (with an estimated daily
turnover of some $4 trillion per day)
and present a large number of attractive trading opportunities.
In short, the FX market is huge, fast and excepting
third-tier or state controlled currencies, very efficient. It’s therefore no surprise that many
(alternative) investment managers of all sizes are tempted to try their hands
at trading currencies but what is or seems strange is how few of these make
genuine and regular profits from their involvement and how many end up as
also-rans and pull out after only a few years.
The answer to this apparent conundrum is quite simply the price i.e. the exchange rate between
any two currencies at a moment in time.
Because the market, as stated, is highly liquid, it’s fair, indeed
necessary for success, to see the price as the sum of the world’s knowledge at
that particular microsecond. Any other analysis
which distances one from the price, for example of volumes or the open interest
in futures markets, is I would argue a distraction rather than a help. There are no dividends in these markets, no
yields, takeovers, mergers or redemptions.
And while currency forecasting is an important sub-set of the job of an
economist, few if any good investment managers are brave enough to apply such
predictions to the business of intraday trading and fewer still survive for any
length of time if they try it.
Instead, the great currency managers employ formally constructed,
durable and usually simple algorithms.
There’s a lot of excitement, even among savvy institutional
investors, about so-called ‘algo-trading’ but, in reality, all that is
happening here is that a computer is generating trading signals by
systematically applying a concise set of rules which have been honed and tested
over the long-term, employing advanced statistical analysis before being
applied to the markets for real.
The trick is constancy.
Any attempt to second-guess the algorithms, once proved, is inevitably
doomed. The set of rules should only be
modified when the evolution of the markets demands
a change not when temporary circumstances suggest it might be a good idea. Regular tinkering intended to improve algorithms
automatically destroys a systematic approach and if an investment strategy is
not applied systematically it is, by definition, random.
An example from the equity markets is illustrative
here. If one investigates the methodology
for the S&P Indices (easily available on the internet), it’s clear there
are about 17 criteria but only about seven formal rules that define an index’s
construction yet, at the same time, the flagship S&P 100 index outperforms
as many as 80% of the investment managers who use it as a performance
benchmark.
If regular ‘improvements’ to trading algorithms do boost
returns, the manager is, again by definition, lucky. Experience shows that such luck will not hold
given this, the most important of all trading rules: “The markets do not exist
for personal enrichment but to teach humility which they do with crushing
regularity”.
