Wells Fargo and Indexing

Early proponents of indexing were Wells Fargo, American National Bank and Batterymarch. Each had a slight variation that was designed to be superior; each had a booster or two from academia and each garnered a small percentage of some of the large pension funds in the United States. Curiously, university endowment funds, run by successful alumni, not faculty, were not among the early entrants.

Timing of the acceptance of indexing was critical. Following the nearly 50% US market decline in 19734, new ideas which might have been rejected just a few years earlier were sought. Ideas that challenged convention were readily accepted since conventional ideas had just demonstrated they could be costly in a decline. Each market phase brings forth its selection of new strategies to support hope and expectations. Indexing was right for the time and the time was right for indexing.

Wells Fargo endorsed investment in the full S&P 500 stock index with only a handful of de-selectees for prudence (reputedly, these handily outperformed even a risk-adjusted measure). American National had a sophisticated sampling technique to reduce transaction costs, a likely source of underperformance. And Batterymarch, thinking that index investors would ignore month to month wiggles of sampling error that would cancel in time, just bought the largest 250 stocks, which were 90% of the total. Batterymarch also tried, and failed, to promote the notion that low cost mechanical replication of any index, not just the S&P, was the goal.

Early clients were happy with the results, which kept pace with active managers even when small stocks pulled ahead in the new, quantitatively-driven market then just beginning. And more money came into the strategy in the billions. Meanwhile, the debates between passive managers, as the indexers were called in error

What is Indexing?

Indexing is an investment practice that aims to match the returns of a specified market benchmark. An indexing manager or tracker attempts to replicate the target index by holding all or, with very large indexes, a representative sample of the securities in the index. Traditional active management is avoided with no investments made in individual stocks or industry sectors in an effort to beat the index. The indexing approach is often described as passive, emphasizing broad diversification, low trading activity and low costs.

Indexing as an investment practice has won acceptability in the last two decades as the mechanical outgrowth of a body of academic insights about markets and managers. Indeed, it was one of the first ideas to be propounded by finance academics from their empirical studies. These pointed out that the average manager would produce sub-average results due to expenses and above average managers would be identified and given more assets until they too became less than average. The system was the trap. After all, index accounts have prices set by all managers. In a sense, these accounts are the most managed of portfolios.

Indexing seems dull. Stock selection is done by a nameless committee at Standard & Poor's (S&P) or elsewhere for other indexes. Proportions are set by market prices, which are the aggregate wisdom of all participants. And administration is relatively simple because transactions are bunched together at the very instant at month end when the index composition may be rearranged.

In the late stages of the one-decision bull market of the 1960s, the idea of mechanically investing in the average just because it was the average would have failed. But in the mid-1970s, when a sharp market correction slayed the old gods and raised up new ones, it was just the thing. Nothing could challenge a roster of active, aggressive managers better than to have a mechanical bunny running the performance race with them and the bunny did not require dog food.

The Future of Hedge Funds

Hedge funds and their appetite for risk continue to appeal to investors, perhaps reflecting the late stages of a bull market, where attitudes to risk shift in two complementary ways: the future appears less risky; and, at the same time, investors' appetite for risk rises. But their bad experiences in 1998, the possibility of worse in the future, and the potential regulatory backlash suggest that their fashionable status as high-end mutual funds may wane.

But one hedge fund manager definitely worth continuing to be aware of is James Cramer of Cramer, Berkowitz & Co., who is also co-founder, co-chairman and contributing editor of TheStreet.com, an online financial publication self-described as "dedicated to providing investors with timely, insightful, and irreverent reporting and bringing accountability to the markets and the media that cover them." This is one of the most entertaining investment sites on the internet.

Problems of Hedge Funds

Hedge funds deal in a paradoxical private language worthy of the worlds of Lewis Carroll or George Orwell. Words seem to be able to mean whatever managers want them to mean: market-neutral positions can bankrupt a fund; long-term capital means a small amount of short-term capital leveraged to the hilt; and to hedge means to take wildly risky positions. Sometimes, even the investors do not know what strategies their funds are using. The rules of LTCM, for example, forbade investors asking what it was that gave the fund its promised edge, ostensibly because of fears of secret investment strategies leaking to competitors.

What is more, it is often not clear if, when hedge funds perform spectacularly well, their high returns owe more to investment judgment, to leverage or to the chance outcomes of purely speculative bets. After all, when a bet is risky, it will make a lot of money if the outcome is as hoped; but when it is relatively safe, the profit is meager unless the bet is big.

Hedge funds claim to be arbitrageurs rather than speculators. But it is generally agreed that there are relatively few real arbitrage opportunities even LTCM returned money to investors in early 1998 claiming lack of opportunities so when you find them, you have to bet big. And when the bets go wrong, you need enough capital or credit lines to stay at the table. Of course, the richer and more powerful a fund becomes, the greater its ability to influence the market in which it deals, often leading to self-fulfilling prophecies. As has been pointed out about Soros, it is not that difficult to move markets when you back your bet with $2 billion and can ride roughshod over markets and governments.

Indeed, hedge funds offer potentially high returns for the lucky few but considerable dangers when their heavy borrowing can damage a whole financial system, and their trading strategies can destabilize whole countries and markets that are not equipped to cope with mass selling of their currencies and equity markets. There is some dispute about the real impact of hedge funds but it seems indisputable that they are powerful and dominant in many markets, including emerging markets, high-yielding debt and mortgage derivatives. And the LTCM bailout suggests that there were real fears that its collapse and the fire sale of its positions would send the global markets into a tailspin. Soros himself provides this counterpoint to some degree in his 1998 book, where he argues that markets have grown so large and powerful they can destroy countries; and markets have become so frightened that they will withdraw capital from most countries in the world. He calls for more international regulation of markets, perhaps through an international central bank or an agency to guarantee loans a cry from the heart that MIT economics professor Paul Krugman has amusingly if harshly translated as "stop me before I speculate again."

In a different article, this one carried by Slate magazine, Krugman discusses LTCM and the possibility that hedge fund compensation arrangements create the incentives to take inordinate risks since managers share in the upside but not the downside. He points out that if someone lends you a trillion, they have effectively given you a put option on whatever you buy: since you can always declare bankruptcy and walk away, it is as if you owned the right to sell those assets at a fixed price whatever happens to the market. He argues that the rational way to maximize the value of the options is to invest in the riskiest, most volatile assets since if you win, you win massively, and if you lose, you merely get some bad press and lose the money you yourself put in.

George Soros and Hedge Funds

A number of energetic people fled from behind the Iron Curtain in the years after World War II. One, George Soros, carried with him a European's sense of philosophy that he applied to understanding markets. Although not trained as an economist or accountant perhaps because of this gap Soros took a psychological and cultural approach to predicting markets. Through his flagship fund, the Quantum Fund, registered outside the United States for flexibility, he would take major positions for or against foreign exchange, derivatives, emerging markets, bonds, private markets or almost anything. Any market was fair game for his group. And he would use leverage to amplify his wagers when called for. Results were outstanding although the volatility was not for the faint.

More recently, he has been writing about his investment style. Coverage in news reverses his trading desk mentality never to discuss his trading positions. And his model book on reflexivity, The Alchemy of Finance, explains his investment approach, which factors investment expectation into structure to make things that seem obvious actually occur. Indeed, the Quantum Fund's name is a reference to Heisenberg's Uncertainty Principle, which describes our inability to predict the behavior of sub-atomic particles.

But Soros's main skill is as a guerrilla investor willing to explore any market, study it more than others, strike with style and quietly withdraw, most often with a profit. In 1992, he became known as "the man who broke the Bank of England" after his attack on sterling forced its exit from the European Union's fixed exchange rate system and reputedly netted the Quantum Fund $1 billion in a day.

George Soros is a complete person and public figure, described variously as hard-nosed financier, philosopher-king, and latter-day Robin Hood. The activities of his charities are well-covered and substantial, especially in the former Soviet sphere, where his Soros Foundation has been more generous than all but two other entities, both of which are big countries. He claims that over half his time now is spent giving money away. So his life is making the transition to that which could be called a private statesman.

Nevertheless, in 1998, Soros suffered some serious setbacks. Not only was his new book on global capitalism poorly received and the Quantum Fund forced into restructuring, but his August letter to the Financial Times on the economic chaos in Russia seemed to trigger the country's debt default and currency devaluation. As the Moscow Times noted, Soros issued what was perhaps the most humiliating statement of his career: "The turmoil in Russian financial markets is not due to anything I said or did. We have no intention of shorting the currency. In fact our portfolio would be hurt by any devaluation." But it was too late: the theory of reflexivity played a cruel joke on its creator and on the ruble.

Understanding Hedge Funds

Highwaymen of the global economy was Malaysian prime minister Mahathir Mohamad's description of hedge funds after the devastation of his country's currency and stock market in 19978, which he blamed on them, particularly the fund led by George Soros. The near-collapse and $3.6 billion bailout of John Meriwether's Long Term Capital Management (LTCM) by fourteen Wall Street banks and brokerage houses in the late summer of 1998 did little to restore the reputation of these shadowy investment vehicles. What are they all about?

Hedge funds typically pool the capital of no more than a hundred high net worth individuals or institutions under the direction of a single manager or small team. Their name originally comes from the fact that unlike most institutional investors, they were able to deal in derivatives and short selling in theory to protect or ''hedge" their positions. But having begun as a way of minimizing risk, the conservative activity of hedging has become the least important of their pursuits.

Usually based in offshore tax havens like the Cayman Islands to escape the regulators and the standard reporting requirements of mutual funds, hedge funds use their freedom to borrow aggressively, to sell short, to leverage up to 20 times their paid-in capital (though LTCM had somehow borrowed over 50 times its capital base) and generally to make big but highly risky bets. They tend to focus on absolute rather than relative returns, aiming simply to make money rather than to beat an index.

But the only real difference between hedge funds and other funds are their compensation strategies. Hedge fund managers tend to be paid for performance, with a modest management fee but a substantial share of the profits the fund makes typically 15-20% though LTCM charged 25%. Otherwise, hedge funds are a diverse grouping of independent asset managers pursuing a variety of investment strategies, usually with minimal disclosure to investors and regulators, and most operating in a niche where they feel they understand the "rules of the game" better than anyone else. Consultancy Financial Risk Management categorizes them into four main groups in a comprehensive overview of the hedge fund market produced with investment bank Goldman Sachs.

First, there are the macro-funds of which Soros's fund is a leading example. These indulge in tactical trading, one-way speculation on the future direction of currencies, commodities, equities, bonds, derivatives or other assets. Their most-publicized activities involve speculation on exchange rate movements, usually shorting the currencies of countries whose economic policies look questionable and whose ability to maintain an exchange rate peg is weak (see Short Selling). Macro-funds constitute the most volatile hedge fund sector in performance terms and their correlation with traditional bench-marks is low.

Second, there are the market-neutral or relative value funds, the kind of fund LTCM described itself as. These funds are supposedly low risk because they do not depend on the direction of market movements. Instead, they try to exploit transitory pricing anomalies, regardless of whether markets rise or fall, through an arbitrage technique called convergence trading: spotting apparently unjustified differences in prices of assets with similar risks and betting that the prices will revert to their normal relationship. For example, LTCM was betting that historically wide spreads between emerging market and US assets and between corporate bonds and US Treasuries would narrow. Of course, as it turned out, history proved no guide to the future as spreads widened and everything moved in the wrong direction at once.

Third, there are event-driven funds, which invest in the arbitrage opportunities created by actual or anticipated corporate events, such as mergers, reorganizations, share buybacks and bankruptcies. Merger arbitrage, for example, involves trading in the stocks of both bidder and target on the assumption that their prices will converge if the deal goes ahead.

Lastly, there are long-short strategy funds, which combine equities and/or bonds in long and short positions to reduce market exposure and isolate the performance of the fund from the asset class as a whole.

Given the lack of a strict definition of hedge funds and the fact that they file no reports, it is difficult to estimate the extent of their activity. Figures for 1998 from the Hedge Fund Association suggest there are between 4000 and 5000 funds with total assets in excess of $250 billion; while according to TASS, a performance measurement firm, there are only 3000 funds but with over $300 billion in assets. But as the experience of LTCM shows, the total assets may not be a true representation of the amount of money dedicated to short-term trading activity since the funds frequently borrow substantially in order to make leveraged bets.

Future of Growth Investing

The epitome of growth investing was the one-decision stock era of the bull market of the early 1970s. The notion was that growth of earnings per share could be projected as a straight line on semi-log paper for the most durable, well managed companies. Predictable growth would be valued richly by investors, which would make equity capital cheaper and easier to raise. In turn, this equity could be invested at higher than average rates of return on capital, which cycled into more earnings per share. And so the money machine would turn. The proper investment strategy was to buy the right companies and hold them forever.

The index funds of the late 1990s get some of the same influence although not by overtly selecting highly regarded stocks (see Indexing and Mutual Funds). But the index tends to be more heavily weighted in those stocks. The one-decision phenomenon of the 1970s and the indexing craze of the 1990s may end up at the same place: ownership of a handful of richly valued companies whose history is not a precursor of their future. And the indexer, like the one-decision investor, is disciplined to stay invested no matter what.Jeremy Grantham of Grantham, Mayo, Van Otterloo & Co. LLC comments:

Historically, at the stock levels in the United States, equity investors have over-paid for comfort (stability, information, size, consensus, market domination, brand names). Historically, equity investors have over-paid for excitement and sex appeal (growth, profitability, management skills, technological change, cyclicality, volatility, and most of all, acceleration in the above).

Paying-up for comfort and excitement as growth managers do for example, is not necessarily foolish, for clients also like these characteristics. Conversely, when a value manager is very wrong as he will be sooner or later he will be fired more quickly than a growth manager. To add insult to injury, the data indicates that the best growth managers add more to growth than the best value managers can add to value, probably because the fundamentals and the prices are more dynamic for growth stocks.

Finally, beyond the financial details of potential growth companies and growth stocks, what are the broad requirements of a successful business? And conversely, what are the features of business failure? We suggest three characteristics which, if found together, will guarantee success for failure. If a business has a combination of passion, authenticity and integrity, it will succeed. In contrast, whenever you find together the three ingredients of mediocrity, arrogance and isolation, the business or indeed the country concerned will fail.

Critics on Peter Lynch

Why not? Of course, the purpose of equity investing is growth, is it not? So the two words seem to be inseparably linked. But perhaps we confuse growth with appreciation. And perhaps we automatically associate past growth with future appreciation. They can differ.

Marc Faber, our guru for Manias, Panics and Crashes, points out, there are two reasons why highly popular stocks, which have become viewed as growth stocks, usually end up as costly disappointments:
First, exciting new markets often fail to keep growing as rapidly and profitably as expected. Second, when a business achieves great success, competitors are attracted into the field, slowing growth and shrinking profit margins for the early leaders. Gottaown stocks are very likely to be losers.

Certainly, when growth stocks start to decelerate, when momentum ends, the price of failure is high. Once a growth stock starts to fall, it loses its momentum attractions, followers of the trend start to desert, forcing the price down further and creating a downward spiral. In such circumstances, there can be high penalties for earnings disappointments. Eventually, growth stocks fail to fulfill their original promise and disappoint investors. Then, as fallen angels they become potential seeds for future value stocks.

Some growth industries never produce any growth stocks: competition is so fierce that no one makes any money. And in a classic article published in the Harvard Business Review over 40 years ago, Peter Bernstein (see Economic Forecasting), makes the important distinction between growth stocks and growth companies:

Growth stocks are a happy and haphazard category of investments which, curiously enough, have little or nothing to do with growth companies. Indeed, the term growth stock is meaningless; a growth stock can only be identified with hindsight it is simply a stock which went way up. But the concept of growth company can be used to identify the most creative, most imaginative management groups; and if, in addition, their stocks are valued at a reasonable ratio to their increase in earnings power over time, the odds are favorable for appreciation in the future.

While Peter Lynch likes growth companies, out of self-professed lack of understanding, he has tended to avoid the high-tech area, where many of the biggest individual growth stock gains of the 1990s have been made (see Internet Investing). His style is also limited to investing in US equities. Of course, it is true that the concept of investment in growth companies as a distinct style of equity investing seems to emerge only in maturing economies. Growth is assumed to be an integral element of any stock selection criteria in many other parts of the world

Peter Lynch, Growth Investing Expert

Peter Lynch is one of the best-known names in investing. He ran Fidelity's Magellan Fund for thirteen years from 1977 and in that period, Magellan was up over 2700%. Lynch managed a vast portfolio, containing over fourteen thousand stocks at any time, and turned over the whole portfolio on average once a year. Yet even in difficult markets, he was almost always opposed to assets sitting in bonds and cash. Instead, he advocated holding good quality stocks with low volatility when going defensive.

Lynch's basic message is that an individual investor can actually find great stocks before Wall Street does: using a combination of intelligence, reflection, perseverance and discipline, it is possible for the average person to uncover great investments. His central point is that products and services you use and enjoy are often provided by excellent companies. If you research these companies and find out whether or not the stock that corresponds to them is priced favorably, you have an outstanding chance at compounding market-beating returns industries and businesses; investigating how a company treats its customers and vice versa. This is the only way I know to find great companies, and nothing beats the feeling when it pays off.

While a fund manager is more or less forced into owning a long list of stocks, an individual has the luxury of owning just a few. That means you can afford to be choosy and invest only in outfits that you understand and that have a superior product or franchise with clear opportunities for expansion. You can wait until the company repeats its successful formula in several places or markets (same-store sales on the rise, earnings on the rise) before you buy the first share.

If you put together a portfolio of five to ten of these high achievers, there's a decent chance one of them will turn out to be a ten-, a twenty- or even a fifty-bagger, where you can make ten, twenty or fifty times your investment. With your stake divided among a handful of issues, all it takes is a couple of gains of this magnitude in a lifetime to produce superior returns.

So what advice does Lynch give to the typical individual investor? Writing in his regular column in Worth magazine, he recommends:

Find your edge and put it to work by adhering to the following rules:

With every stock you own, keep track of its story in a logbook. Note any new developments and pay close attention to earnings. Is this a growth play, a cyclical play or a value play? Stocks do well for a reason and do poorly for a reason. Make sure you know the reasons.

Pay attention to facts, not forecasts.

Ask yourself: what will I make if I'm right, and what could I lose if I'm wrong? Look for a risk-reward ratio of three to one or better.

Before you invest, check the balance sheet to see if the company is financially sound.


Don't buy options, and don't invest on margin. With options, time works against you, and if you're on margin, a drop in the market can wipe you out.

When several insiders are buying the company's stock at the same time, it's a positive.

Average investors should be able to monitor five to ten companies at a time, but nobody is forcing you to own any of them. If you like seven, buy seven. If you like three, buy three. If you like zero, buy zero.

Be patient. The stocks that have been most rewarding to me have made their greatest gains in the third or fourth year I owned them. A few took ten years.

Enter early but not too early. I often think of investing in growth companies in terms of baseball. Try to join the game in the third inning, because a company has proved itself by then. If you buy before the line-up is announced, you're taking an unnecessary risk. There's plenty of time (ten to fifteen years in some cases) between the third and the seventh innings, which is where the ten- to fifty-baggers are made. If you buy in the late innings, you may be too late.

Don't buy cheap stocks just because they're cheap. Buy them because the fundamentals are improving.

Buy small companies after they've had a chance to prove they can make a profit.

Long-shots usually backfire or become no shots.

If you buy a stock for the dividend, make sure the company can comfortably afford to pay the dividend out of its earnings, even in an economic slump.

Investigate ten companies and you're likely to find one with bright prospects that aren't reflected in the price. Investigate fifty and you're likely to find five.

What Is Growth Investing?

Growth investing is one of the two classical styles of investment. There are numerous different definitions of the style and some confusion about the precise relationship between growth companies and growth stocks. But a focus on growth is generally contrasted with value investing, which tends to rely more on quantitative methods of analysis. Growth investing tends to be based more on qualitative judgments about the kind of companies that will offer remarkable growth rates and exceptional returns performance.

Growth stock investing arose as a definable concept in the United States of the 1930s the counterpoint to the safe, secure income investing of the depression years. It was presumed that companies with a past record of growth in revenues and earnings had the momentum to carry them into the future. And they had to go farther into the future or at greater rates of growth than the market had already accorded in its discounting through current prices. T Rowe Price, who first set out the principles of growth stock valuation in the 1930s, wrote:

Growth stocks can be defined as shares in business enterprise that have demonstrated favorable underlying long-term growth in earnings and that, after careful research study, give indications of continued secular growth in the future.

In order to turn a capital commitment into appreciation, the growth investor needs prescience about earnings or rate of growth or the market's willingness to pay for future events. At certain times in the market for example, in the late 1960s and early 1970s and, more recently, in the late 1990s the growth investor has been rewarded with handsome returns. Those returns have in part been the result of an increase in the number of growth investors rather than a change in the valuation systems used by an existing population of investors.

And the agreement runs backwards in that those equities that have appreciated are assumed to have growth characteristics. Almost any list of the best managed companies a popular and recurring article in business publications will be composed of those stocks that have had an unusually favorable price performance for some past period. Growth stocks may see the future through the rear view mirror.

Future of Global Investing

Recent research indicates that Americans are more likely to invest in their local regional Bell operating company than in any other. Considering that everyone's local operator cannot be a better investment choice than any of the other six, this finding suggests the importance of investors' psychological need to feel comfortable with where they put their money. Perhaps it relates to the endowment effect, a phenomenon noted by behavioral finance, where people set a higher value on something they already own than they would be prepared to pay to acquire it.

But if people still do have a predilection for investing in familiar stocks, they are likely to leave largely unexploited international investment opportunities and hold sub-optimally diversified portfolios. It is tempting to conjecture that such a psychological attitude might be even more pronounced in the highly diverse cultural contexts of European countries. Such an attitude could explain the lack of cross-country portfolio investments within Europe, and suggest that the internationalization of European individual portfolios will be a slow process even in the wake of the euro.

On the other hand, the potential development of a European identity and the increasing tendency to think European rather than French or German a tendency that is likely to be enhanced by the advent of a shared currency could make European investors less reluctant to hold equity stakes in companies residing in a European state different from their own. Perhaps European home bias will fade.

Of course, none of the reasons for home bias apply to the individual global investor with the funds, access to broking services and time to conduct research on the opportunities in the international equity market. It seems likely that home bias and low market correlation will diminish over time as the interconnections of the global economy become closer and the confidence of investors in overseas markets grows. But in the meantime, by leaving some lower risk and higher return possibilities relatively unexplored, they might help an investor to formulate an international investment strategy that can beat the market consistently.

There is also now a vast amount of information on global investment opportunities available on the internet. Any point on the globe is as accessible as next door. It is cheap and often free. It shifts control of time, depth of information and source to empower the user. And it is open: anyone can come in taking its knowledge and offering skills. Financial centers are described on a satellite connection, not geographic coordinates or proximity to other financial talent centers. Work takes a different form in time and space with email, videoconferencing and the internet, all of which are available at a price for the single user at his or her own site. Location becomes irrelevant.

A visit to South Africa from the United States, for example, requires probably a week of preparation, a week there, and a week of decompression on the other side a total of three weeks, assuming we are efficient. Compare that with a day on the internet. How much information could one get on South Africa in the course of a few hours on the web? The information might be different, but it is going to be a large volume in a short period of time. You would understand the culture and the issues, and you could gain a lot of information that is hard to find out otherwise.

According to that well-known fan of investment management, Bill Gates: ''Anyone who is not intimately involved with the internet and the web does so at extreme peril." This statement applies with particular force to investment analysts and private investors. For those of us who are dedicated to moving our craft forward, being ahead of others and using the best tools available, the internet is our mandate.

Critics on Gary Brinson' Theory

If global investing is superior to investing in only one market, why do so many investors hold disproportionate amounts of their portfolios in equities of their own domestic markets? Even sophisticated institutional investors, such as pension funds and insurance companies, tend to concentrate well over three-quarters of their equity funds in domestically quoted shares, a phenomenon known as home bias. Evidence of wide discrepancies between national market performances over certain periods of time suggests that these investors would maximize their returns and minimize their risks more effectively by diversifying more fully across stocks in different countries.

Various explanations for home bias have been advanced. These include IMF officials' arguments that it is, in large part, due to the substantial risks of adverse exchange rate changes, which cannot be guarded against with standard hedging techniques. Currency risks may be compounded by the different supervisory environments in particular markets, by fears that capital controls may be instituted, by taxes on international trading or simply by a wish to avoid the time and expense of maintaining and researching a more widely spread international portfolio.

Such reasoning is supported by arguments that the benefits of international diversification arise merely from the fact that different stock markets have their shares concentrated in different industries. For example, the UK privatization program of the 1980s means that utilities are a more important part of the London market than elsewhere. Similarly, investment in the Swiss market implies a disproportionate bet on banking stocks, and investment in the Swedish market a commitment to basic industries. The implication is that global investing offers nothing more than exposure to additional industries.

Yet home bias on the part of institutional investors seems to be more a result of government restrictions on the amount of foreign assets pension funds and insurance companies in any given country are allowed to hold. It also may arise from the way in which fund managers' performance is assessed through reference to a local market index: even if passive indexing is not their dominant strategy, there is inevitably a strong incentive to own a good slice of the index's components. And industry analysts are often more prevalent than country analysts in fund managers' offices, suggesting a disposition to choose industrial over international diversification.

There is evidence that the covariances of global markets may be sliding closer, though Japan may be a special case. For the other members of the G-7, coordinated banking policies and facilitated information flows should tend to drive markets into a more steady alignment. On the surface, such an increase in stability could be seen as beneficial for business but would be a lessened benefit for portfolio investors attempting to diversify risk.

For example, closer links between European economies following the introduction of the euro will increase the incentive for US investors to diversify into European markets. At the same time, this may also strengthen the relationship between different European stock markets, reducing the incentive for diversification within Europe.

Gary Brinson an Expert on Global Investing

Gary Brinson is a staunch advocate of asset allocation techniques and a pioneer of global investing. In 1974, the firm now known as Brinson Partners (then a unit of First Chicago) was one of the first to invest overseas. Brinson led a management buyout of the unit in 1989 and the firm was later acquired by Swiss Bank Corporation. The latter has since merged with Union Bank of Switzerland and as a result, Brinson directs over $300 billion in institutional assets, making it one of the world's largest money managers. Brinson is also co-author with Yale finance professor Roger Ibbotson of a book about asset classes, investment theory and international investing.

The Swiss banks were interested in Brinson Partners for its money management business but perhaps even more for its ability to bring North American investment techniques to Europe and elsewhere in its network. Features that are taken for granted in the United States like performance measurement, incentive compen sation, quantitative tools and hedging are less familiar in Europe (see Performance Measurement, Quantitative Investing and Risk Management). At first, the relationships were rather loose with interns coming to the Chicago headquarters for training and management coordination with the Swiss management largely by encrypted videoconferencing. More recently, the risk management and tighter controls at headquarters have dictated closer ties.

Brinson has promoted the professionalism of investment management by taking an active part in its industry association, the Association of Investment Management & Research (AIMR) and its Research Foundation. He is an advocate of small, steady incremental gains in improvement of standards. Similarly, he is an advocate for small changes in asset allocation. Consistent with the Swiss style of investing, major swings are generally unlikely to take place.

Brinson argues strongly that investment decisions should focus first and foremost on markets or asset classes since that explains roughly 90% of returns. The key is to consider overall portfolio risk rather than the risk of individual assets: a sound asset allocation combines diverse asset classes in ways that increase returns without an equal increase in risk or reduce risk without sacrificing returns.

His global asset allocation strategy rests on four basic principles:

• Think global.
• The value of asset classes should not rise and fall together.
• Focus on the long term.
• Monitor and adjust allocations to accommodate changed investment climates.

Brinson believes that in a relatively short time, it will seem as odd to most investors to discuss a Europe fund's country allocations as it does now to discuss a US fund's relative exposure to each of the fifty states. In his mind, country concerns will be minimal in comparison with company concerns.

What is Global Investing?

Don't put all your eggs in one basket, the principle of portfolio diversification, is widely accepted by investors. It is normally thought of in terms of the number of assets, industries or companies across which an investor is spread: a well-diversified portfolio contains equities (as well as bonds, cash, etc.) in industries whose returns do not move together. And the lower the correlation between the returns on the various equities or other assets, the less wildly the value of the whole portfolio should swing.
Less frequently is diversification considered in relation to owning equities and other assets from different countries. But with many national markets often highly uncorrelated, this form of diversification would seem to offer the strongest potential for reducing risk, while at the same time promising enhanced returns. Particularly for investors in one of the highly valued markets of the developed world, buying foreign equities uncorrelated with their domestic market should, in principle, make their overall equity portfolios less risky and more valuable.

So global investing is in the first instance about asset allocation between equities, bonds, cash and other instruments; and second, about investing in global markets. Asset allocators benefit by diversifying across asset classes; international investors benefit by diversifying their portfolio across assets in a range of different countries. The key factor for the latter is the degree of integration of the real economies of the countries concerned. It is important to understand co-movements among different markets: the more markets move together, the fewer the benefits of international diversification.

Global data for 1998 reveals significant performance differentials between regions. The MSCI World Index rose 19.7% but only two regions Europe at 26.5% and North America at 27.1% ex ceeded that. Across the emerging markets, performance ranged from a spectacular 137.5% gain in South Korea to an 83.2% decline for Russia (see Emerging Markets). Though somewhat narrower, differences in the developed world are just as striking: Finland gained 119.1% while Norway declined 31.2%. This large regional performance differential underscores the importance of a global portfolio strategy. An asset allocation strategy that on average correctly anticipated these differences would have added significant value.

Global investment provides a security hedge and a currency hedge. Frequently, investors do not separate the two (see Foreign Exchange). Nearly all academic studies suggest that the question of currency hedging should be dealt with explicitly and should not be treated as incorporated automatically within the overall global allocation. And it is important to recognize that currency hedging may be costly and can increase risk. The Asian meltdown in 1998, for example, led to the double whammy of currency devaluation and stock market collapse.

Richard Olsen’s Reactions on Critics (Part 2)

Currency attacks are becoming a depressingly common feature of the global economy. But the exact timing of the onset of an attack is notoriously difficult to predict. Richard Olsen has developed a global financial early-warning system, which tries to do the same thing as a gadget that tells someone when they are getting their next heart attack.

Olsen comments:
We have been looking at the data now for many years and we have learned a lot about what really makes a market function successfully. And, most importantly, how the components within the market that is, the market makers, the medium and long-term investors interact, and what is required to build a healthy market or, in reverse, what leads to a negative market with large-scale shocks.
For obvious reasons, such a system would be of immense interest to regulators and speculators.
The core determining factor of a currency's value is the health of the real national economy, especially the balance-of-payments. current account. If there is a surplus in the current account, that is, a country sells more goods than it buys, then buyers have to acquire that currency to purchase goods. This adds to foreign reserves and bids up the price of that currency. Conversely, a current account deficit implies the need to sell the local currency in order to acquire foreign goods. Persistent current account deficits, particularly if allied with relatively low foreign reserves, indicate a problem.

A currency's value is also affected by levels of inflation and the domestic rate of interest. High rates of interest and low inflation make a currency attractive for those holding assets denominated in it. So typically one country raising interest rates while others remain the same will raise the value of its currency as money flows into the country. This will have a limited effect if the fundamentals are wrong.

Comparative inflation rates, interest rates and balances of payments will all give clues to likely medium-term movements of a currency. But a key factor determining short-term currency values is market sentiment. There can be a self-fueling process in which enthusiasm for a currency, or the lack of it, drives the exchange rate. Speculators might decide, as they did during the European Monetary System debacle of 19923 and the Asian and Russian crises of 19978, that a currency is overvalued or simply that there are speculative gains to be made by selling it.

Currency attacks are triggered when a small shock to the fundamentals of the economy is combined with systemic weaknesses in the corporate and banking sectors. One facet of such systemic weaknesses is the effect of belated hedging activity by some economic actors in the economy whose currency is under attack. The more these actors try to hedge, the greater is the incentive for others to follow suit. This unleashes a whiplash effect, which turns a potentially orderly depreciation into a collapse of the currency. In other words, if speculators believe a currency will come under attack, their actions will precipitate the crisis; while if they believe the currency is not in danger, their inaction will spare it from attack attacks are self-fulfilling. The magnitude of the shock necessary to trigger an attack need not be large, which makes predictions very difficult. Nevertheless, it is possible to draw some broad conclusions on the vulnerability of currencies to attack. In particular, there must be a pre-existing weakness, which will prevent the authorities from conducting a fullfledged defense of the currency by raising interest rates. The weakness may not be lethal in itself (though it can become lethal once the situation deteriorates) so it is a necessary condition but not a sufficient condition for a speculative attack.

Self-fulfilling attacks may affect any country with a fixed exchange rate and high capital mobility that is in the gray area between fully safe and sure to be attacked. Recent research suggests that countries with strong trade links with a country that has recently experienced a currency crisis is highly likely to face an attack itself the growing phenomenon of contagion in foreign exchange markets.

Richard Olsen’s Reactions on Critics

Why have we focused on studying the forex markets? Researching these markets is like doing research in a nuclear reactor, where basic processes can be studied in states of high energy. In such an environment it is easier to identify the forces that drive financial markets and distinguish them from random market effects.

People fail to realize the importance of forex markets to support the globalization of the "investment business." Relative to trade flows, investments across borders have increased much more dramatically. The forex markets have to be able to accommodate the demands of these international investors, who want to sell their foreign holdings at a moment's notice. Even though the forex markets have grown, the growth has been insufficient to support the requirements of an international investment community.

The introduction of electronic transaction systems has speeded up transactions in forex dramatically during the past six years. There is a side effect that has been neglected by many of the commentators. Similar to the money multiplier, there is a market liquidity multiplier. If the efficiency of the transaction system increases, then transactions are settled much more quickly. This has the effect that liquidity dries up much more rapidly than in the past.

My inference is that today's forex markets are far too small to support our globalized financial community. The effect will be erratic price movements, as we saw on 7 October 1998 with the 20% shift in the dollaryen exchange rate.

The introduction of the euro will make things worse. I think that we have to look at the euro as a merger of the European countries. Europe will thus become like one big football stadium with a strong US counterpart. The world will thus have two big football stadia. The stadia need wide roads, that is, highly liquid forex markets. Unfortunately, the new dollar euro exchange rate will not be sufficiently liquid to absorb the large shifts of capital that will occur between the dollar and the euro.

Professor Amartya Sen, who received the 1998 Nobel Prize for Economics, explained in great detail that starvation is not a problem of a lack of food, but deficiencies in the distribution system. We face a similar situation with the financial markets, where the fundamental economy is in satisfactory shape, but the allocation system, that is, the financial markets and in particular the forex markets and the balance sheets of the banks, are in deep trouble.

Critics on Richard Olsen

Smart as it is, there are times when the approach of Olsen and his colleagues has failed to work. Like other more simple data mining and historically based methods, it works in periods when currency movements are following a trend but gets whipsawed with penaliz-ing transaction costs in trendless markets. And during a change in the trend, O&A might identify a turn but not know the difference between a minor and a major turn.

Yet this group comes closer to modeling how the foreign exchange world really works than others. When there are new academic insights, they are likely to note them early.

A broader social counterpoint to today's forex markets is that with this daily volume of electronic, invisible money flowing throughout the world, a single nimble trader can drive a monetary institution to the wall. A trader is often compensated by a share of the trading profit, which can put tens of millions into his or her pocket. The trading institution takes the risk and the trader takes the profit: a true asymmetrical payoff scheme operates to pyramid risks. A central bank seeking to dampen its currency swings may come forward with a few billion but this is typically something that a single trader could command. In these circumstances, a central bank attempting to influence a currency is like sending a bicycle onto a superhighway.

The size of forex trade has played its part in the series of currency crises in emerging nations during the 1990s. The capacity for massive daily foreign currency flows to take place made possible the almost overnight collapses of the currencies of Thailand, Indonesia and Russia in 1997-8. As confidence in the economies of these countries fell away, demand for their currencies dried up as investors took their capital out or stopped bringing it in. Governments had tried to buy their own currencies to underpin their value but could not keep up with the sellers. When they stopped their own forex activity, the forces of demand and supply saw the baht, rupiah and ruble in turn crash in value, deepening the crisis of confidence and economic slowdown.

Some commentators are now recommending a tax on forex dealings: for example, Nobel Laureate James Tobin has warned that free capital markets with flexible exchange rates encourage short-term speculation that can have a ''devastating impact on specific industries and whole economies." To avoid this real economic havoc, he advocates a 0.5% tax on all foreign exchange transactions in order to deter speculators, a remedy dubbed the Tobin tax.

There are three rationales for the proposed Tobin tax: the first is that the volume of foreign exchange transactions is excessive fifty to a hundred times greater than that required to finance international trade; the second is related to the first reducing volatility offers more independence to national economic policy-makers; and the third is simply the tax-raising abilities of such a tax, which is linked with the view that the financial sector is relatively undertaxed.

Foreign exchange guru: Richard Olsen

In the pre-radio and telephony days, information about markets moved by post, horses and even by carrier pigeons. Investors with information in one market would send their instructions to other markets and success was often an outcome of the speed of transferring the messages.

Today's global environment also puts a premium on speed, but it is not measured in days or hours but nanoseconds. Currency-trading departments are decentralized so that individuals, usually young, nimble and quick, can make massive decisions on their own. The trading rooms of major institutions trading currencies for their own accounts often contain no one over the age of 35, none with bonus possibilities less than multiple millions and all eager to take risks to achieve personal gain.

It is perhaps not surprising that currency markets trading in hundreds of billion dollars a day, open 24 hours and with information moving so fast that there is always the chance of an information advantage, would attract speculative attention. And not surprising either that the value of speed and ability to grasp all the markets' information at once would attract academics building new models. One of these, and one of the best, is Richard Olsen of Olsen and Associates (O&A), a high-frequency data processing firm in Zurich in which Dean LeBaron has personally invested.

A visit to O&A, in a refurbished flour mill alongside Zurichsee is like a visit to Silicon Valley. Attire is California casual, tee shirts and jeans, though Olsen does wear a tie to see clients. Dogs and bikes sit outside offices while their owners are huddled over computer keyboards. Conversation is usually in English though it is hardly the first language for the majority. Academic disciplines are mathematics, economics or almost anything else. The common characteristic of the people is smart, very smart.

Olsen and his colleagues are the best at acquiring and analyzing high-frequency data, using very advanced mathematical techniques to forecast currency movements. By high frequency, they mean second by second, and forecasting might be for an hour or so ahead, perhaps even a week if long-term the value of high-frequency forecasts decay rapidly as the information that produced it is disseminated.

Foreign Exchange Investing

Foreign exchange (forex or FX) markets form the core of the global financial market, a seamless twenty-four hour structure dominated by sophisticated professional players commercial banks, central banks, hedge funds and forex brokers and often extremely volatile. Many investors, particularly American ones, tend to ignore currency movements, and few financial analysts are trained to analyze the details of forex markets. But this is a mistake. As the 1997 Asian crisis and its aftermath vividly reveal, foreign exchange these days tends to lead economic activity. And the foreign exchange markets are huge, growing and increasingly powerful.

According to the Bank for International Settlements, the central bank for central banks, average daily turnover on the world's foreign exchange markets reached almost $1,500 billion ($1.5 trillion) in April 1998, 26% higher than when it last measured forex flows in 43 different countries three years earlier. Transactions in-volving dollars on one side of the trade accounted for 87% of that forex business. Almost a third of all forex trading takes place in London, by far the world's largest center, with New York and To-kyo second and third. Although London forex trading grew more slowly than New York over the three years to 1998, its average daily turnover remains greater than New York and Tokyo combined, having risen from $464 billion to $637 billion.

To put these figures in perspective, daily trading volume on the New York Stock Exchange (NYSE) is only about $20 billion; activity in short-term US government securities is around ten times that at $200 billion; and so at $1,500 billion, foreign exchange trading is seven and a half times the volume of trading in short-term US government securities and seventy-five times NYSE trading. This volume is far greater than the size of foreign currency reserves held by any single country. The forex markets cannot be ignored: for their size and forecasting ability; and for the potential that developments in these markets have for the future of the dollar as the world's dominant currency.

In the past, trading in the real economy controlled relative currency relationships. Since most currency flows were to settle trading patterns, there was a balance as goods and capital moved at about the same speed. But now the leads and lags are the other way around. While in name, forex markets exist to facilitate international trade, in practice, the bulk of turnover in these markets is attributable to speculation. Because financial flows are many times the size of trade flows and because financial flows are nearly instantaneous, currency market levels now tend to set trade: if a country's currency becomes low relative to others, domestic producers find it easier to export. The market sets the economy.

Where next on emerging market?

While it is true that fixed-income management is different from hedge funds, the issue of SEC registration is not really significant since it is more an issue of paperwork than a review of investment precepts. Hedge funds operating in bond markets have the same theories and practices as the most advanced fixed-income people, so there is a direct connection between the development of active bond management and LTCM. The latter is an extreme case but it comes with overconfidence in the models, and with a large segment of bond and derivative managers using the same models at the same time since they share the same education and same data-bases.

While historically stocks have provided substantially greater returns than bonds, there still may be good arguments for fixed-income investing. As the ads for investment products are all obliged to say, past performance is no guarantee of future performance, and many believe that bonds may outperform stocks over the next few years as stocks' recent strong performance makes them less attractive and as deflation becomes a more potent force than inflation.

Indeed, much of the recent interest on the plus side has been in the fixed-income market. While the stock market has been demonstrating volatility and generally crashing in emerging markets, the US bond market has been steadily strong. There have been two unusual circumstances: one is an inverted yield curve, where long-term rates are lower than short-term rates; the other is a flight to quality, with the quality preference spread widening dramatically. These previously occurred together in 1981, a highly inflationary period, and in 1990, when inflation was declining yet clearly positive. But to find a precedent for both happening for a sustained period, we need to look back to deflationary times almost a century ago.

It seems to be conventional wisdom that the US and European economies are in a healthy state of moderate inflation. But perhaps instead, they are mixed economies with some features still experiencing inflation, principally wages and salaries, and others experiencing deflation, principally those associated with materials and commodities. Today's forecasts are that there is likely to be even more competition from lower wages from the developing countries, which are experiencing extremely heavy deflationary pressures and that these pressures may spread to the developed world. With the reality of deflation plus relatively high real interest rates, bonds become very attractive.

The bond markets may also be boosted by the expansion of the eurobond market in Europe in the wake of the single currency. All new government debt in the eleven euroland countries will be issued in euros, market practices will be harmonized giving incentives for more corporate bond issues in euros, and the market may become more transparent, liquid and efficient. It seems likely that the euro fixed-income market will come to resemble the US bond market.

Finally, it is often valuable to challenge unchallenged precepts. One of the most widely accepted assumptions is that US govern ment short-term debt is the riskless base against which all other returns are measured. But is that always so? Not necessarily: since US debt is almost perpetual and refinanced, what happens when the debt holders, often non-US lenders today, have other uses for their funds? The largest holders of US Treasuries are Japanese and it is not difficult to imagine that they would have other uses for their funds than holding short-term US instruments. And if they and others withdraw from this market, the riskless security could become quite risky.

Critics on Andy Carter's Theory

One of the major disadvantages of investing in bonds is that they seem to underperform equities over the long term. This conventional wisdom is strongly expressed by Wharton finance professor Jeremy Siegel, who argues for the vast superiority of the equity markets as an investment vehicle. Siegel calculates that a dollar invested in a representative group of US stocks in 1802 would have grown to $559,000 in 1997 after adjustment for inflation (which reduced the value of the dollar to seven cents over that period). In contrast, a dollar invested in long-term government bonds, short-term bills or gold would have grown after inflation to $803, $275 and $0.84 respectively.

So while bonds are usually thought to be less risky than equities, in terms of inflation-adjusted returns, they have actually been more risky for most of the nineteenth and twentieth centuries. Siegel estimates that the real return on equities over almost two hundred years was 7% a year compounded, compared to 3.5% for bonds and 2.9% for bills. What is more, the superiority of stocks grows and their riskiness falls the longer they are held: they outperform bonds and bills 60% of the time over a single year, 70% over five years, 80% over ten years and 90% over twenty years.

The credit risk of bonds is a further downside, particularly during bull markets as investors become more willing to accept risk, which tends to reduce the spread or risk premium that poorer risks pay. When the market is jolted by bad news, the spread invariably widens again dramatically, causing the poorer risks to fail. Notorious recent examples include the aftermaths of the December 1994 Mexican devaluation and the August 1998 Russian default and devaluation. The latter led to the flight to quality and widening of spreads that was such a problem for LTCM.

The old argument in favor of investing in bonds is that they provide current income and some degree of stability of capital. It is generally agreed that the shorter your investment horizon and the lower your risk tolerance, the higher the percentage of bonds you should have in your portfolio. But should the bond portion of a portfolio really be actively managed? Research suggests that professional forecasters find it difficult to beat a simple approach that always predicts that future interest rates are equal to current rates, and that after accounting for management fees, bond funds tend to underperform simple passive investment strategies.

Is the whole of active fixed-income management a fraud perpetuated by managers to increase fee income more than the gains, even if achieved, that could result? Certainly, bond markets are thought to be very efficient and fees should be examined carefully and, ideally, avoided entirely if possible. For example, it is hard to see how management can increase returns when the yield spread between thirty-year corporate bonds and thirty-year Treasuries is under 1%.

Then again, for individual investors, trading in the bond markets can be difficult since in many cases, the markets are not very transparent. While the bid-ask spread on US Treasuries is small because of the very liquid market, the spreads on corporate and foreign bonds can be as high as 56%. This is because bonds are usually traded over the counter with no real marketplace. Investors must rely on brokers who have a big incentive to give the bond seller and buyer the worst possible price in both directions as they make the difference.

Fixed Income According Andy Carter

"If Andy Carter did not invent active fixed-income management, he is one of its very earliest practitioners," comments Peter Bernstein, someone well qualified to observe fixed-income history. And perhaps nothing epitomizes the development of investment management more than the changes in fixed-income practice in the last 30 years. Classic investment finance reserves the function of providing funds to run a business to equity. Borrowing, whether short-term or long-term, is matched to the payment flows of specific projects for interest and repayment of principal.

We have come a long way since this basic early understanding. Today, fixed-income instruments have rather little to do with specific projects but are another device, like equity, to raise permanent capital. As such, bonds are expected to be refinanced and bond quality is as much a measure of the likelihood of new investors to step forward to replace those who wish to move on to other investments as it is a measure of the profitability of business projects.

Bonds in the 1950s and 1960s were purchased by institutional investors for the major part of their portfolios and were normally held to maturity. These investors might have occasionally altered their quality preference, using rating agencies to attest to bond quality and covenants, but the modest changes they made were almost entirely through their selection of new issues. It was a slow, deliberate process. And expected bond returns were likely to be the coupon return to maturity and the repayment of principal. Many fixed-income portfolios were carried on an institution's accounts at par or purchase price, unadjusted for fluctuations in market value. After all, there was unlikely to be a sale before maturity so recognition of market fluctuations by changes in interest rates or creditworthiness was immaterial.

But then came the emergence of active fixed-income management. Sometime around the bull market excesses of the late 1960s and the collapse of equities in mid-1970s, the thought occurred to Andy Carter and a few others that bonds presented an opportunity for swaps. By studying the underlying characteristics of one bond, it might be possible to find a comparable instrument at a cheaper price. And with the knowledge that a trade could be done with someone who lacked this insight, perhaps a small but promising gain could be captured. Thus, the bond trading business and bond capital gain business were born.

Andy Carter looks like a flashy, dour Scot. Wearing a signature bow tie, he is totally immersed in the full range of fixed-income active management, having been there from day one. It tells us much about Carter that he followed his father as the top student at Loomis School and donated a residence hall there in his family's name.

Carter started in the investment business at Irving Trust in 1964. But his exploration into active fixed-income management began with the Harvard University endowment in the mid-1960s. Just as interest rates began a huge rise, the opportunity was available to show how a bond portfolio could be energized by trading compared with the historic strategy of buy-and-hold.

Carter took active bond management to a new firm, Thorndike, Doran, Paine & Lewis in Boston and then started his own operation in 1972. At both places, he collected a blue chip roster of institutional clients who expected, and received, a different style of bond management and paid equity-like fees for the service. He collected mandates of billions from demanding clients for management. Currently, he is chief executive officer of Hyperion, a bond management firm based in New York City.

Today, fixed-income management is the most quantitative of investment disciplines, incorporating the most extensive use of sophisticated derivatives and advanced statistical techniques of risk management (see Quantitative Investing and Risk Management). However, the well-publicized near demise of LTCM was active fixed-income management carried to its extreme. And Andy Carter can take the credit or blame for starting it all.

Understanding Fixed Income

Fixed-income securities or bonds are generally thought of as safe rather boring investments, lacking the risks associated with equities. After all, no one seems to worry about the US government defaulting on its debt and US Treasuries make up a significant proportion of the bond market. In practice, though, it is possible to lose vast amounts of money by getting the bond markets wrong. Because bonds appear to have a more definable risk profile than equities, leverage tends to be more easily obtainable. And high confidence in understanding fixed-income relationships may lead to excessive leverage and unexpected out-comes, as the case of Long-Term Capital Management (LTCM) in the late summer of 1998 vividly illustrates.

Bonds are debt instruments, securities sold by governments, companies and banks in order to raise capital. They normally carry a fixed rate of interest, known as the coupon (usually paid every six months), have a fixed redemption value (the par value) and are repaid after a fixed period (the maturity). Some deep-discount and zero-coupon bonds carry little or no interest, instead rewarding the buyer with a substantial discount from their redemption value and hence, the prospect of a sizeable capital gain.

As Michael Lewis explains in Liar's Poker, his entertaining account of life among Salomon's bond traders in the 1980s, the one thing you need to know about bonds is the relationship between their prices and interest rates. In short, as one goes up, the other goes down. This is because the fixed income paid by a bond which when calculated as a percentage of its market price is its current yield is equivalent to the rate of interest. If rates go up, the relative attractiveness of newly issued bonds over existing bonds increases. And since coupons are fixed, for yields to be comparable to those on new bonds, the price of existing bonds must fall.In most developed countries outside the United States, government bonds issued in the domestic market have traditionally dominated fixed-income investors' portfolios. But with the opening of markets around the world, the range of choices has increased enormously in recent years. There are now markets not only in the government bonds of developing and transition countries (see Emerging Markets) but also for numerous other debt instruments: corporate bonds, junk bonds, stripped bonds, mortgage-backed securities, convertibles, and so on. In the United States, the Treasury bond market is now significantly smaller than the mortgage and corporate bond markets.

Credit quality has become a key issue. For example, emerging market and corporate bonds generally carry a risk premium over US government bonds, with higher yields to reflect the more variable creditworthiness of their issuers and the greater risk of default. Periodically, bonds of an entire category sovereign debt, real estate, junk become nearly worthless. Under these conditions, there is a preference for liquidity and quality, making refinancing difficult or impossible for less than top quality issuers.

Interest rates and credit risks are crucial considerations in fixed-income investing but perhaps most important of all is the expected future path of inflation. Inflation is bad for bonds, eroding their value as prices and yields, unless index-linked, fail to keep pace with rising prices. What is more, higher inflation or the prospect of higher inflation is usually associated with higher interest rates, as policy-makers tighten monetary conditions in order to try to contain inflation or protect a weakening currency (see Foreign Exchange and International Money). This makes cash more attractive, pushing down bond returns.

The yield curve is a means of comparing rates on bonds of different maturities, as well as an indication of the tightness of monetary conditions. Longer term yields are usually higher because of the greater degree of time and inflation risk. They are a good indicator of expected trends in the rate of interest and the rate of inflation. When short-term rates are higher, there is an inverted yield curve. It is vital for active fixed-income investors to look for changes in expectations about the future rates of interest and inflation. Key indicators of these are the strength of the economy and the frame-work of fiscal and monetary policy (see Economic Forecasting and Politics and Investing). Bond markets tend to like signs of economic weakness since strong growth might trigger inflation. They also like fiscal policies that dampen the economy, squeezing out inflation.

Indeed, bond traders have become increasingly effective in preventing governments from introducing policies that may reignite inflation, hence driving interest rates higher and bond prices down. Their actual or implied threat to flee the markets in response to such policies has led to them being called vigilantes, and to presidential adviser James Carville's famous remark, ''I used to think that if there was reincarnation, I wanted to come back as the President or the Pope. But now I want to be the bond market: you can intimidate everybody."

The Future of Financial Engineering

Andrew Lo's research results and the implication that there are pockets of predictability in the stock market lend support to contrarian strategies of buying losers and selling winners (see Contrarian Investing). But he is less convinced by investment strategies based on the insights of behavioral finance into psychological biases inherent in human cognition, which aim to take advantage of individual "irrationality" As financial engineering attempts to define itself as a field with connections closer to the engineering disciplines than more traditional finance, associations are being set up, and the general engineering community does not quite know what to do. Patenting is becoming a big issue. Recent changes in patent laws and interpretations, along with encouragements for universities to do more patenting have led to an explosion of new patents. Some of these are in financial engineering but it is not clear which can be defended. Certainly, financial patents will have an impact on the efficiency of markets and the rate of financial innovation.

Financial engineering is also having an impact on banking. Innovation in combination with electronic technology is creating a world in which maturity transformation turning short-term deposits into long-term loans, the central function of banks is unnecessary. Economic agents individuals, households, companies will no longer require this service. Their portfolios of assets and liabilities will be broadly matched in maturity terms: short-term assets will match short-term liabilities, longer-term liabilities will offset longer-term assets. As a result, as Peter Martin of the Financial Times suggests, "traditional banking is dying. But the grieving throng around the deathbed face a long and expensive vigil."

Finally, what about market innovations? Financial innovations have been fast and furious over the past two decades. But why are market innovations so slow in coming? We have known for a long time what to do: integrate global markets electronically; pay shares in decimals not fractions; open the specialist books and stock exchanges like the New York Stock Exchange; record and display publicly the questions and answers exchanged by companies and analysts. Indeed, we could even go further and encourage insider trading, bringing insiders' wisdom into the market sooner rather than holding out, waiting for culprits to take advantage of us. It could be done, merely by identifying fewer insiders and letting them trade, at which point they would identify themselves. All of these things and more could be done in a stroke.

Counterpoints to financial engineering

It includes traditional market efficiency arguments against active management, such as Bill Sharpe's arithmetic (see Active Portfolio Management). And even if it is possible to beat the market, and notwithstanding the fact that past performance should not be the sole criterion for judging investment managers, the riskiness of active strategies can be very different from passive strategies (see Indexing). Such risks do not necessarily average out over time, and investors' risk tolerance should be part of the process of selecting an investment strategy to match their goals (see Investment Policy).

A second counterpoint is the set of arguments against quantitative investing, and notably its reliance on backtesting and data mining (see Quantitative Investing). Engineering, by the very nature of its development and application, builds on whatever is accepted theory at any given stage of the cycle. Investment theories tend to lurch forward in leaps, usually after the disappointment of a prolonged bear market. New theories emerge, correcting the ills exposed by a calamitous decline and engineering applies the new wisdoms.

It should not surprise us that the applications of today's financial engineer seem internally consistent, sound and almost unassailable. That would always be found after decades of reconfirmation of market and portfolio theory. But we should not be lulled into complacency by a catechism built on data of only a few decades. Nor should we imagine that portfolio theory, as we know it today, is the end of investment knowledge. There will be new theory and new engineering to apply it. But it may have a different label than the contemporary financial engineering. Finally, one of the consequences of the development of computer and financial technologies (as well as the long bull market) is the incredible growth in electronic trading. This has both good and bad implications for ordinary investors. On the positive side, the tools developed by cutting-edge financial institutions over two decades ago are now available to the individual household. Yet as with most technologies, the tools are more advanced than the general population's understanding of how to use them properly. Although trading costs have come down dramatically for the individual investor, the possibility of doing serious damage to one's nest egg is even greater.

Andrew Lo and Financial Engineering

Where else but the Massachusetts Institute of Technology (MIT) would you expect to find a course track called Financial Engineering? For a while the Sloan School of Management was not really accepted at MIT though its graduates were among the most sought-after in the job market for newly-minted MBAs. But within the science-oriented faculty, business education was hardly taken as seriously as Alfred Sloan, the donor of the facilities, hoped it would be.

Now that has changed. Finance has gone quant: higher mathematics is a regular feature of security pricing, risk management and business strategy. Professor Andrew Lo is one of the key people responsible. He is a first-rate scholar who, like others in this volume, can straddle academe and business. His research output is huge, often in collaboration with other leading lights who appear in the Journal of Finance, the Journal of Financial Economics, the Journal of Econometrics, the Review of Financial Studies and the many other publications still being added to the reading lists of professors and practitioners.

The burgeoning field of financial economics has produced a group of young professors who now hold endowed chairs. Just a decade or so ago, they were pre-tenured stars full of research ideas sprung from the basic efficient market hypothesis. They were going on to the next level or two, testing and applying these theories to specific valuation, portfolio strategy and risk problems. They showed their students, who were to become the star practitioners in institutions, how to do investments the modern way. Many of this group won a coveted Batterymarch Fellowship for research when little other funding was available. Andrew Lo, of course, was one of the most promising of that group as a winner in 1989.
Lo's research interests run the gamut of today's financial interests and his papers are among the most thoroughly researched of the field. Students call him an inspired teacher, perhaps because he believes in the worth of his subject matter. And in addition to his heavy teaching load, he carries an administrative burden as the director of the Laboratory for Financial Engineering, in fact its founder, at MIT. Somehow, he also finds time to help leading investment firms through consulting projects as well as steadily maintaining active parenting of a young toddler.

In addition to being the co-author of the first major financial econometrics textbook, Lo has a book published in early 1999 entitled A Non-Random Walk Down Wall Street, an obvious counterpoint to Burton Malkiel's classic book of almost the same name (see Market Efficiency). As his title suggests, Lo's research indicates that there are some elements of short-term predictability in stock returns and that it may be possible for disciplined active managers to seek them out, exploit them and "beat the market."

Financial engineering is the key to superior performance. Lo uses the analogy of the exceptional profitability of a pharmaceutical company, which may be associated with the development of new drugs via breakthroughs in biochemical technology. Similarly, even in efficient financial markets, there can be exceptional returns to breakthroughs in financial technology. Of course, barriers to entry are typically lower, the degree of competition much higher and most financial technologies are not as yet patentable so the half-life of profitability of financial innovation is considerably smaller.

Understanding Financial Engineering

Financial engineering is, in essence, the phenomenon of product and/or process innovation in the financial industries the development of new financial instruments and processes that will enhance shareholders', issuers' or intermediaries' wealth. In the New Palgrave finance dictionary, John Finnerty lists countless recent financial innovations from adjustable rate preferred stock to zero-coupon convertible debt but these all can be classified into three principal types of activities: securities innovation; innovative financial processes; and creative solutions to corporate finance problems.

All these innovations are implemented using a few basic techniques, such as increasing or reducing risk (options, futures and other more exotic derivatives see Risk Management), pooling risk (see Mutual Funds), swapping income streams (interest-rate swaps), splitting income streams (stripped bonds), and converting long-term obligations into shorter-term ones or vice versa (maturity transformation). But to be truly innovative, a new security or process must enable issuers or investors to accomplish something they could not do previously, in a sense making markets more efficient or complete.

Finnerty describes ten forces that stimulate financial engineering. These include risk management, tax advantages, agency and issuance cost reduction, regulation compliance or evasion, interest and exchange rate changes, technological advances, accounting gimmicks and academic research.

The emergence of financial engineering has also been influenced by the realization on Wall Street in the early to mid-1990s that there was a need for a new kind of graduate training. The financial institutions wanted people with heavy mathematics skills and some finance training, but had previously been fed from a haphazard network of different programs. Universities began to re spond to the demand by setting up masters programs in financial engineering and they were helped by the fact that the physics job market was at an all-time low due to the end of the Cold War.

The Future Trends of Emerging Markets

Perhaps rather it was a natural consequence of the modern portfolio theory taught in the United States, to diversify and take higher risks, coming on the back of what wsa then a ten-year-old bull market. From the developing countries' position, private investors were offering capital at no annual interest rate (we called it equity; they called it free, without management strings), which was more attractive than bank or government lending. It was a meeting of lovers and there was a love fest. And now, they have matured with all of the obligations and responsibility that come from the next age level.

Mobius selects the largest countries as the ones with best future potential presumably for the attractiveness of their domestic markets. The first rush of emerging markets was for export sales and that is now over. He is right to emphasize places like Nigeria and Egypt. And he is right in the sense that if he is wrong, these overpopulated countries will not tolerate a world with such huge disparities of communications and living standards.

But before we get to 2010, we must deal with the traumas of the late 1990s. Since the beginning of the Asian crisis in July 1997, there has been an approximately 50% decline in emerging markets. It started in Asia, became most visible and most illustrative in Russia, with about a 90% decline, approximately the same as in Indonesia, the fourth largest country in the world in terms of population. And pressure built up in Latin America.
rates, in higher markets, to take them out. And even if not at higher levels, they take them out anyway because emerging markets on the whole look like a considerably less attractive place to invest than they did five years ago. This is a world-wide phenomenon, not just limited to Indonesia, Russia and Latin America.

What is it all about? The mixture of rising nationalism and deflation is very potent negative medicine for emerging markets. Reform of banking systems means banks have to recognize bad loans. Interconnectivity means that when something happens in one part of the world, the rest of us all feel it. This is not necessarily a dramatic buying opportunity except for those people who can watch the hourly news. And yet, we are setting up the conditions by which the long struggle of the workout period can take place. It is probably some distance into the future, but the early dramatic decline has certainly been felt.

In the meantime, there will be continual turmoil in these countries, promoting more nationalism, more separation from the international community and yet more necessity on the part of the developed nations, especially the United States, to support them.

China may be different in the sense that it has a high surplus of dollars with its very positive trade balance with the United States, and it may come out of this phase as the dominant emerging market. Mobius is right about the necessity for structural reform but this country seems destined to dominate its region and possibly to be the next sole superpower. It is a tremendously powerful force in the region and in the world, and the group that is running China now and in the next decade is very competent. We should pay careful attention to them.

Meanwhile, the United States itself looks increasingly like an emerging market. As with most emerging markets, it depends entirely on an inflow from outside its own borders in order to survive. There is a negative savings rate, and debt cannot be liquidated on its own but only rolled over, a characteristic of an emerging market. And it is very much an overbought emerging market having extended a very great boom for essentially the last 18 years. But more than that, the United States is an emerging market that has turned over its financial responsibility to the rest of the world. The degree to which the country borrows in dollars is helpful. But the degree to which dollars are held by foreigners is harmful since foreigners can start liquidating those dollars in order to meet their own demands. As an emerging market, it is not clear that the United States would meet the IMF requirements for borrowing, a strange concept given the extent to which it is perceived to be the safest
Think of a swamp fire, or a fire in a coal mine, where underneath the ground there is a common smoldering heat source, which every once in a while flares up to the surface where it must be put out. Firemen come in and douse it with water and fire extinguishers and that flame goes away. Six months later, it comes up again.

This is what the conditions are today in emerging markets. In Indonesia, South Korea, Thailand, Malaysia, Brazil, Russia, Mexico one after another we get a flare-up. But it is all the same thing. It is a preference for risk-averse investing. It is a preference for guaranteed returns. And it is an aversion to the downside risk of a free market that extracts a penalty for over-exuberance. We have to treat the basic fire, rather than just the flare-ups.

Each emerging market considers itself unique in attempting to solve its own problems. But the problems are quite common. In order to rebuild their economies, most emerging markets have borrowed heavily in dollars in this capital-plentiful period. Investors have also invested dollars in those economies and now plan, at higher

The Trend of Investing Mindset

The ability to move from market to market assumes that investments and their environments are disconnected, that market movements are not strongly correlated. But in these days of global banking and instant communication, that condition is less likely. Markets and investments in those markets may be increasingly synchronized.
In the past two decades, as emerging market investment grew dramatically, globalization permeated our financial systems. Now there are some clues of a cyclical return to local and national interests. If so, investments by foreigners in any market may be treated harshly.

For example, some now argue that the rapid expansion of emerging stock markets in recent years is likely to hinder rather than assist faster industrialization. According to this view, while stock markets may be potent symbols of capitalism, paradoxically, capitalism often flourishes better without their dominance. The inherent volatility and arbitrariness of stock market pricing in developing countries make it a poor guide to efficient investment allocation. Portfolio capital inflows from overseas lead to interactions between two inherently unstable markets: the stock and currency markets. Such interactions in the wake of unfavorable economic shocks may exacerbate macroeconomic instability and reduce long-term growth.

Emerging market investment depends on steadily growing liquidity to be able to pay back investors at higher levels in a foreign currency. This works when the market is going up and money is coming in. But in the reverse, liquidity is tight; the ability to pay foreign creditors is lacking and confidence plummets.

Thus, emerging market investing may be a long-term cyclical phenomenon and not a steady, one-way path to riches. Certainly, the emerging market investment phase of more than the last decade is over. Not only has capital been destroyed and confidence shattered, but the idea of capital flows for superior return from developed countries to needy, developing ones is gone. The latter do not want the funds on anything like the terms that would be required.

A common theme of this book is that investment success is most often observed where the market requirements and investor personality are one. The old shibboleth that "investors don't pick markets, markets pick investors" is more true in emerging markets than elsewhere. And Mark Mobius's style, hard work and tough mind are exactly what was needed in emerging markets. These markets may undergo a change. Will he?

Five Central Investment Attitudes

Diversification: this is particularly important in emerging markets where individual country or company risks can be extreme. Global investing is always superior to investing solely on the investor's home market or one market. Searching world-wide leads an investor to find more bargains and better bargains than by studying only one nation.

Timing and staying invested: as Sir John Templeton says, "the best time to invest is when you have money." In other words, equity investing is the best way to preserve value rather than leaving money in a bank account. As a corollary, an investment should not be sold unless a much better investment has been found to replace it.

Long-term view: by looking at the long-term growth and prospects of companies and countries, particularly those stocks that are out of favor or unpopular, the chances of obtaining a superior return are much greater.

Investment averaging: investors who establish a program from the very beginning to purchase shares over a set period of intervals have the opportunity to purchase at not only high prices, but also low prices, bringing their average cost down.

Accepting market cycles: any study of stock markets around the world will show that bear or bull markets have always been temporary. It is clear that markets do have cyclical behavior with pessimistic, skeptical, optimistic, euphoric, panic and depressive phases (see Manias, Panics and Crashes). Investors should thus expect such variations and plan accordingly.

In assessing emerging market investments, Mobius stresses the importance of constantly being aware of influences and biases. These are strongest in the places where you spend most of your working and leisure hours and from where you obtain most information. For this reason, the emerging market investor must continually visit all the countries in the emerging market areas and read news and research reports originating from all over the world. (However, as a counterpoint, the internet now makes available a wealth of information on individual markets and countries perhaps better and less costly in time and effort than that obtainable on the ground.)