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.