10 June 2010

On Speculation and Investing

The intersection of speculation and investment management, together with the relationship between these two often separately-categorised activities, escapes sufficient scrutiny. It is important to look at this relationship and therein attempt to discern investment activities that may or may not be pernicious to any party involved: the investor (or their client), other market participants, the market itself and even expanding right out to the scale of the economic society hosting the market concerned. There are potential moral and economic conundrums that emerge as a result of many investment activities, including speculation. The history of finance is regularly delimited by marker events in which finance’s potential for destruction overtook its huge capacity for (the support of) economic creation. Time is more than nigh for a novel anticipatory and preemptive approach to financial oversight. Given the burgeoning, potentially long-overdue review of financial sector regulation, there is much ado at present contrasting the roles of international finance in efficient capital allocation – true or productive 'investment' – and what some in very high places deem the 'virtual casinos' represented by some markets. There is a popular perception that the financial industry is in competition with the rest of the world, i.e. a trader’s gain = society’s loss. Where untrue this needs to be corrected (financial firms are mostly in competition with each other); where true the harm must be eliminated.

It is now retrospectively incontestable that the dogmatic recent past of the Friedmanian ‘Washington Consensus’ concealed an inevitable loose cannon. The expected self-regulation of economic laissez faire due to a firm’s self-interest does not materialise – reference Greenspan himself. The general admissal of what we always knew (that it was total baloney) is somewhat extraordinary. The shame of those that denied this no-brainer-to-a-five-year-old must be borne equally by those who promoted it and the politicians who acquiesced; when the cat is away the mice will always play. Large, 'cornerstone' financial institutions have been seen to self-destruct, floundering spectacularly with a shocking speed, triggering a domino chain of panic, bankruptcy and rescue pleas. Moreover, the debt raised in recapitalising the crippled international credit-banking system has led to a large scale transfer of privately-generated risk into the public space. It is a possibly sad but incontrovertible fact that free market capitalism in the end sought massive recourse to state control. Herein lies something undeniably perverse.

Consensus is now high that regulation needs reworking. The ideology, never mind the politics nor the economics, that underpins and sometimes window dresses international finance is now something of a vacuum. There are important, and contentious, debates around various Tobin taxes, new central clearing houses and novel oversight mechanisms, but there are no real new ideas, no new paradigms being mooted. As for being under the spotlight and the magnifying glass with a renewed vigour, the likes of Lehman and AIG, for example, cannot protest. The camp that insisted capitalism’s arch defence mechanism against undisciplined firms – the grim reaper of bankruptcy – was left to enact its role had to pipe down and look away; they realised that the firms were so important that letting them fail would literally let the world fail. Others have little argument and governments have little choice as they have had to pay out an unprecedented rescue package in the name (and purses) of their electorates.

Amongst everything else, much talk is again about speculation. Only recently the FT is highlighting, for example, the two hedge funds Winton and AHL’s large short sterling positions. Proclaimed or not, the tone of the article is unmistakably ‘should they be doing that?’, ‘is that trade acceptable?’ etc. – and this is in the FT. As regards the now AAA-fatigue-rated term ‘credit crunch’, I don’t believe most would say that speculation per se is particularly the card that brought the pack down. That, we know, was excessive leverage in a myopically-bubbling US property market, efficiently lubricated by unethically sold, unaffordable loans that were packaged and rebranded as good credit. More on leverage soon. But it must also be examined whether speculation formed more than one of the other weak cards. The property market was not only bubbling due to genuine, real demand; speculation in property was also very active and now must face close inspection.

For some there is a sense, perhaps a seemingly intuitive sense, that speculation in itself is predominantly a non-ethical activity[1]. Simple gambling. But gambling on what exactly? Some may feel that betting (or having your pension fund manager, or your employer's treasurer, bet for you) on the British Pound versus the American Dollar is less morally substantiated than betting on the future of British Aerospace or Google. There’s a logical flaw in this line of thought however; it is a fact that all investment, i.e., purchasing any financial asset (including your house) is gambling. No rational person (and in many but unfortunately far from all cases, no asset manager investing your money) would purchase any asset with the expectation that the value of that asset will fall. The timescale envisaged for this rise may of course vary. Hence they expect the value to rise -> they are betting on a rise -> they are gambling. Is this wrong? Is this ever wrong? Or is this beneficial? Always, or sometimes? The key to more understanding of these issues may be found in analysing either their effects, or in the mechanisms behind the moving prices of the assets concerned, or both.

In a capitalist system, when we are talking about the stock market for example, the accepted wisdom states that the cumulative effect of all the interested parties buying and selling shares in individual companies (= the 'market') is to optimise the capital allocation process to those companies, directing it to those that will use it best. What 'best' means is another, very complicated matter, one that I would love to discuss, but not here. We will have to assume that 'best' means doing the right thing, i.e., being paid for 'making' what people 'want', being innovative, creating employment etc. The point of this kind of market allocation process is that the best decisions are supposedly made if the market is composed of lots of independent agents forming their own opinions of such matters – the wisdom of crowds effect. Not surprisingly, this, again, opens another gigantic can of worms, but again, that is a great subject that is not to be dealt with here. Although cognitive dissonance makes me feel ill, to continue we will have to falsely assume that this process always works well, or at least should, or at least could. So, self-interested individuals gambling in company shares leads, in theory, to money being invested where it should. Very few people, subject to my horrendous assumptions, which elsewhere do need serious attention, would have a problem with this.

Now what about other assets? Currencies, for example, are funny ones. Investing in a currency is different, because you can't buy one without simultaneously selling another. Buying USDJPY means selling Japanese Yen and buying the monetary equivalent in American Dollars at the prevailing rate. So what does investing in this relationship mean? It means that you think the $ will gain in value with respect to the Yen. So is it more 'wrong', or less 'right' to speculate in this manner compared to investing in a company? It could be possible to persuade yourself that this kind of bet has no functional benefit. Lots of people do. But anyone prepared to speculate in this manner obviously has the expectation that the $/Yen will rise in the future, and they may have very good reasons for such a view. They may have more information than others as to why the price will move in that direction. Their action of speculative trading incorporates that information in the price, i.e., in an open, transparent market (as currency markets relatively are), they share their information with everyone else. If you are a large American company that has to buy a lot of Yen tomorrow to settle an outstanding order, then incorporating this information in to the new lower Yen price is definitely to your benefit.

So speculation encourages information-absorption into prices. Speculation leads to arbitrage whereby prices of equivalent ‘things’ are harmonised across markets. And is this 'good'? Yes, clearly, it can be, for everyone. It is undeniably to the common good that the maximum information relevant to any monetarily-valued ‘thing’ is incorporated in to its price as fast as possible. If you think this may not be true then you must accept that there remains at least one potential trader that is privy to some private information about something’s future value and you would prefer that information to remain hidden. Not a very satisfactory conclusion. So is speculating (on currencies) therefore always good? Well, maybe, that depends. There is still possibly a case, and for many most definitely a latent lingering hunch, that 'excessive' speculation is wrong. People I know in the business have a sometimes-expressed view that everything is ok until the speculative capital in any market becomes dominant. But how much is excessive and when is this excessiveness dominant?

One problem impossible to underestimate with speculation, in all markets, in fact in much of human behaviour, is inappropriate herding. Note that financial markets, although appearing as somewhat esoteric constructions, are nothing more than systems of aggregate human decisions. The actions of the original, independent, information-carrying agents, those that trade based both on their direct contributions to supply and demand and on the information they hold, alter prices, pushing them up or down. Of course, others simply follow and continue to fuel the momentum, or trend as it's less glamorously known. And they in turn attract others. Who attract even more – it’s the kind of compounding in finance that we really don’t want at all. Don’t be shocked at the naïve reality of ‘asset allocation’ or investment decisions made by the generality of the investment management industry. They really do just follow each other. I won’t go into detail here, but it is very easy to demonstrate and many have already done so. If currency ‘trend following’ has ‘been doing well’ recently, then they all pile in, like flies on … In currencies, for example, there are many hedge funds, the subcreed known as CTAs, whose raison d'etre is only trend following (or at least it represents about 80% of what they do). They are paid a surprising amount to simply buy what went up yesterday and vice versa. Ok, this is a slight oversimplification, but not an excessive one. Herding is a natural, inevitable (at present), emergent property of the current system. At this juncture then, surely the whole point of the market: that of incorporating all relevant and known information into prices, the price discovery mechanism if you must, just falls apart. It is simple to then assume that ‘real’ information is no longer driving prices, prices diverge from true value, and that the crucial component is uninformed bubble-chasing, bubble-fuelling join-the-trend-ism.

Is this what happens? Should this happen? If such a marked phenomenon develops then, if the price is being supported (or depressed) by an irrational, codependent herd, then surely this ‘incorrect’ price can be corrected? Someone can ‘buck the trend’. Are there not other traders around who deduce that when herding behaviour is dominant they should trade against it, cancelling out the effect? Can the 'greed' of speculation be therefore used to calm the fever? When an irrational trend (a bubble in any other market) is boiling away under its own exuberance in foreign exchange, is there sufficient intellect (and investible capital) out there looking for excessive speculative herding and being paid to cancel it out? Maybe not. There are certainly counter-trending investors out there, but are there enough? Should there be more? One salient fact: it is without doubt more difficult to sell a counter-trending strategy to investors during a prolonged period (dozens of months) of bumper trend-following returns. At this time the pure trend-follower will however be a relative money-magnet. There are significantly different incentives for the money manager choosing to be with or against the trend. Trends seem to be characterised by going on too long, overshooting massively and ending very quickly and unpredictably, much to the unbridled chagrin of many a CTA investor. One thing that the CTA managers seem unable to do after all, is predict when any trend is going to fall apart. And maybe, if such managers exist, the small number that are good at forecasting a blow-up are not going to be feel superincentivised to tell everyone else. We have therefore, at least two systematic mechanisms that are entirely pro-trend: it’s an easier strategy to sell and even if you successfully sell a counter-trend strategy, a profitable counter-trender won’t benefit from sharing their secrets.

Timescales, another weak point in capitalism’s armour against poor economic management, are not without import. During the trend, the investor will tot up a positive compounded return, month on hubris-laden momentous month, until such time they will suffer a couple of negative months when the party’s over. By this time, the fund manager’s performance-based commission is in the bank – I have yet to see a symmetric fee structure whereby the manager charges a negative fee during a negative month. Ok, most managers operate a ‘high water mark’ fee policy and only start charging performance commission again once the previous loss is regained, but funds can go bust or just be closed in the meantime. On the other hand, the putative counter-trend strategy stands a chance of coming out much better in the end, but their investors will need to stomach, apologies in advance, ‘investment horizons’ of many months, if not years. When it comes to irrational prices, as with everything else in humanity, the truth will out, but it can take an awful lot longer. Capitalism’s credit-driven cash flow demands, often a positive economic force via incentivisation, are intrinsically short-termist. They temporarily favour the ‘wrong’ but profitable strategy of today that blows up in a year over the longer term ‘correct’ view that would leave you in the black in 3 years’ time. Money management is a commission business; performance fees are calculated monthly: go figure.

So does this kind of behaviour, in any market, only lead to harm and things like the much maligned 'currency runs' in foreign exchange markets? Surely. Maybe. Not that the collapsing value of one currency against the other is necessarily the bad bit, rather that it rose to an unsustainable value in the first place. An important point to note when it comes to thinking about the possible deleterious effects of excessive speculation: for every buyer there must be a seller. In the, again, FT the other day, someone wrote in amusingly asking for the counterparties to all the current short sterling positions to identify themselves, so he made sure he didn’t invest with them. In currencies, what does this counterparty availability mean? If you keep buying USDGBP one year into a 10% trend, does the existence of a seller at this elevated price mean there is someone who thinks the opposite of you? In currencies, most probably not; international foreign exchange is such a gigantic enterprise, the continuous demand for exchanging of currency makes for a very deep and liquid market; you’ll find a counterparty to your trade at any price. But what about the oil futures price during the highs of mid 2008? Commentary was all on speculation-driving prices back then. Without doubt trend-following commodity traders were buying and supporting that trend. At the time there was little investment potential elsewhere, which left buying primary industry capital much in vogue. Portfolios everywhere ‘diversified’ with an inventory of oil, nickel and gold. And who were they buying the futures contracts off? The producers presumably; they would be more than content to cash in today’s production via a rising futures market. While the trend lasts, for oil today just as for Dutch Tulip bulbs back in the day, it’s a bonanza for the producer and the speculator – but poignantly the opposite for the oil user – and that’s the, err.., entire world economy. When the oil bubble popped, 140 to 40 USD remember, the trend followers had collected lots of performance fee off their investors and the producers had sold oil still in the ground at an interstellar price. Everyone else had lost out.

All the same, while climbing a bubble’s peak, a neurotic cognitive disconnect reigns amongst the mountaineers. There is a general acceptance that something is wrong, that fundamental value’s importance has reduced to a drop in the barrel; but an inconsistent orthogonal view simultaneously holds: that prices will continue to rise – with oil at $140/barrel there was consensus on a $200 forecast. When only speculation is in charge, the capacity for harm is unbounded. Let’s not entirely unreasonably imagine for a second that the ‘real’ price of oil should have been $80 when it hit $140. Accepting this hardly rigorous estimate, effectively we conclude that oil had a $60/barrel irrationality-premium. With ball-park global oil consumption at 80 million barrels/day, the global misspend on this premium comes to circa $5B/day: the gigantic extent of wasted capital near unimaginable.

So, there is a conspicuous argument to be made that, for example, speculative trading can at least sometimes be generally and devastatingly harmful to the structure of world for the benefit of the very few. What to do? Bluntly limiting speculation by misguided regulation will impede the price discovery process, the kind of market self-correction mechanism that is the whole point in the first place. However, encouraging processes like, i.e., counter-bubble corrective speculation must be increased, as they are surely lacking. Innovative thinking is also required to remove the inherent conflict of interest in the timescale problem. Is it a good idea to incentivise the antibubble speculator and how could we do that? How about charging performance fees on a retrospective moving average? Could states ever be persuaded to take out a short bubble position? How about the World Bank?

Bubble-chasing is another example of capitalism’s unfortunate race to the bottom side effect. Think ever more underpriced sub-prime mortgage-backed securities: “We know they are selling them cheap, but …” If something that turns out to be sub-optimal (in an objective, public good, sense) develops and is found to be profitable (in an individual, subjective sense) then it is emulated. Despite the inherent negative ‘externality’ (e.g. a currency bubble), if one firm joins the party, then to remain competitive others are similarly obliged. This brings us to the fundamental issue with capitalism: capitalism is based on market economics, but, triple-underlined but, its individual component economies are too simply calculated; they are narrow and frighteningly ignorant. Much has been said to decry central control’s naïve analysis, the kind that leads to Maoesque, Stalinist disaster. Now capitalism’s near wilful ignorance of hidden, delayed cost is tarnishing the sheen of its place on the economic system trophy shelf. Because the buyer is unaware of, or not subjected to, the cost of the externality, the buyer won’t pay to avoid it, hence the firm who wishes to avoid it will be penalised. Look at oil. There’s no need to consider the contemporary subject of earth’s growing carbon storage-heating system, just look back to the child-poisoning leaded petrol of the recent past. Once an externality is known (notwithstanding the argument that they should be actively sought out), the role of the state that chooses to practice capitalism is to impose correct treatment of the externality by the subeconomy of concern. As we have, most justifiably, globally accepted a doctrine of cost-based market forces, accounting for externalities now represents the most fundamental and crucial challenge of the today’s globalised society. For any microeconomy, be it ‘cable’ (USDGBP currency trade), disposable nappies or heating fuel, if the externality is not ‘internalised’, i.e. taken into account, then the economy of that system is simply incorrect. Implication: the sums are wrong; result: the capital and resource allocations it directs are wrong; in the end it is all just wrong.

It’s actually worse than this; it’s complicated by the fact that the ‘true’ value of something is not independent of its trading, market value, which itself may be dominated by the effect of irrational speculation, aggressive shorting, or some other ‘non-fundamentalist’ position. There is a feedback mechanism back from market value to fundamental value; what something is worth is in part dependent on what people think it is worth. It’s not difficult to instinctively expect this to be the case, but it’s more systematic than that. Back to the credit foundations of capitalism: a large part of a bank’s valuation is based on its ability to lend; that of other companies on how much they are able to borrow. Both sides of this ‘credit score’ are judged predominantly as a function of their share price, those doing well in the stock market are judged to be able to lend or borrow more: hence real value and trading value are intimately linked. Once irrational factors assume a dominant stance in share values then the vicious lunacy feedback cycle can commence.

So errors in real value are compounded by the feedback of irrational components in market value. And at times this can become supercharged with leverage. Leverage can pollute the market as a ‘geared’ position amplifies the effect of any irrationality it may be based upon. There’s also a deeper, subtler issue with borrowing money to increase the size of your bet: it messes up the market’s information aggregation mechanism. Leverage introduces what may be non-linearity between information and the capital deployed to incorporate it (i.e., bet upon it). In other words, if you are willing to bet x based on a view/forecast/alfa/information of size X, and you then leverage your bet to 2x, this does not now imply that you ‘feel’ information of importance 2X; you still feel something like X. The extra, leveraged x does not cost you as much as the original one, so you require less ‘information’ to justify it – just look at UK mortgages pre credit crunch. None of this would necessarily present a problem if the playing field of access to leverage (credit) were level across the market. But it’s not. Due to the incentivisation structures and strategy timescale issues previously discussed, the bubble-, inter alia, fuellers have an enhanced, asymmetric access to increased leverage. Market participants who are more likely to contribute to an irrational trend make more money in the short term, giving them the apparent but misguided luxury of having more access to leverage, further increasing the impact of their activity. The far-from-the-madding-crowd strategy cannot access the same gearing and hence is even more relatively undercapitalised.

I acknowledge that, for example, a financial bubble is not as obvious an externality as is pollution. However, as a bubble introduces unexpected large costs to everyone else, I think the analogy is powerful. If the financial industry and society started to view speculative bubbles as another form of externality that requires correction then mindsets could be changed in a beneficial manner. In finance, the ‘externalities’ are often contentious and always complex. No one sector can act as analyst, judge and jury in this arena; it’s too complicated and biased vested interests inhibit rigour. A healthy world demands a collaborative ongoing search for financial market externalities. We need to end the capitalist-regulator war of attrition. Apart from its ineffectiveness, it is also ultimately childish. The tripartite body composed of financial practitioners, regulators and academia need to get their heads together on the same team. States and multi-lateral organisations need to incentivise the community of capitalists to collaborate in the elimination of the externality. The alternative, the one practiced to date, is that the externality-ignorer will always be short-term profitable and one step ahead. The ultimate source of appropriate stewardship has to come from within. This means financial firms need persuading that externality avoidance, being of the common good, is also of their good. We have seen through the feedback mechanisms between real and market value that all financial entities are interconnected. Effects, whether rational or not, spread across the entire system and can be dangerously accelerated with asymmetric leverage. Hedge funds, according to some the devil incarnate (on the whole, but not exclusively, incorrect), certainly should play their role in reshaping and renavigating the regulatory landscape. For sure there was hedge fund involvement in the risk-myopia preceding the credit crunch. And some of them rightly fell. However, there were no cataclysmic hedgie-related explosions in this financial crisis; there was no LTCM II. Two principal reasons: firstly, everyone had already learnt from LTCM (by definition, historical covariance matrices cannot be crystal balls) and secondly, hedge funds primarily trade their own money. A more relevant statement on this entire subject is impossible to compose. Collaborative oversight’s persuasion mechanism should encompass all possible avenues: financial (fiscal?), practical and moral, with a sprinkle of compulsion here and there. An international collective needs to be constructed, well represented by all agencies, whose aim in life is to seek out and protect from the ‘externality’. The practitioners are the ones who will continue embarking on new strategies that may produce an unassumed infectious risk contagion. It is only they who can really help. Yet independent self-regulation is simply impossible, not in least due to the incomprehensible complexity of a modern financial institution’s structure. Simplify those structures = simplify the global tax system. Time-old regulator-trader adversity is entrenched and produces an ineffective stalemate. Left vs right wing party politics are now irrelevant. The only sustainable successful financial market future will build on a paradigm that fills in the trenches and invites everyone to the same table to sort the mess out. Imagine a world in which the citizen is as poignantly aware of the ‘leverage danger’ level as we regrettably are of the far more arbitrary ‘terrorist danger’ alert. Insane levels of leverage based on simple mass cognitive errors certainly require control. But governments can’t do it; only compel it.

Our inherited conservative vs liberal, capitalist vs socialist tribalism is now a trite, irrelevant legacy. The holistic analysis of international financial markets needs to finally get serious and be evidence-based with a cumulative, self-correcting scientific approach. The effort to answer such deep questions as ‘when is speculation harmful?’ or ‘when is liquidity provision saintly?’ has to be ramped up by orders of magnitude, that’s if it even exists at all today. Let’s not even mention short-selling. The uncertainty is large, but the time has long since elapsed when we could assume that nothing is wrong. Definitely warranting further scrutiny are: ‘non-productive’ speculation, short selling, leverage, arbitrary derivatives-based leverage, any non-centrally cleared instrument and any other ‘difficult to value’ (seldom-traded) instrument. Note that I do not imply that I think these practices are necessarily universally harmful. We do need however to find out if and when they are and take appropriate action. When validated, society should be informed of their beneficence where appropriate. Finance too must have its advocacy when and where credit is due. An industry of analysis, meditation and modelling of investment practices, whose aim is to titrate the societal beneficial from the best-avoided needs to get organised, incentive-aligned and respected. The intertwined roles and effects of trading in systemically-important financial instruments demands proper inspection and governance. Throwing stones in financial ponds makes ripples that travel far. Before you throw, you need to feel that. The academic aspect of oversight is certainly underfunded. Compare the budget of the Pentagon to that of the SEC, and then realise that they are mandated to protect from risks of not dissimilar, catastrophic magnitude. Significantly today, the moral case is massively undervalued: much glory may be poured upon the temporary profits of the (un)witting externality seller; little honour bestowed on the one who saw the warning signs. Can we incentivise the ethics? At present they are arbitrary; but what if they (or their effects) are quantified? Moral compasses are misaligned on an incomplete economic ideology; a recalibration is required. The true capitalist cannot be against this; the capital allocation process is governed by competitive advantage based on relative performance. If externalities are considered globally, relative profitability is not changed. All boats rise and sink on the same tide. The water level is invisible. Destruction of hidden externality leads to less future destroyed capital. It’s more expensive to correct future mistakes. Hence more capital tomorrow for better allocation elsewhere. Correct, intelligent regulation must at last be aligned with self-interest, therein lies the challenge.

© April 2010

[1] John Kay, The long and short of it. Comments on the difference between profitable investment and gambling.

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