RP CLIENT ARTICLE APPEARING IN FT-SE GLOBAL, JUNE 2015

THE PRICE IS RIGHT

by Christopher Cruden, Managing Director, Insch Capital, Lugano

On 17^th 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 16^th 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”.