Nobel laureates, market timers and pension funds in Chile

Published at The Long Room, Financial Times Alphaville
A Spanish version available at America Economía

A quick riddle: which of the following quotes corresponds to a strong believer on market efficiency, someone who thinks asset prices are always right (and if they were not, who are you to tell). – Or, if you will, which one comes from an efficiency skeptic, one who found that price volatility cannot be explained by fundamentals alone and bubbles are around the corner.

Nobel laureate #1:

“It’s not easy to make a lot of money fast, and that you can go for years losing money, even if you’re a very smart person”

Nobel laureate #2:

“If they know – (how bad the market is in setting absolute prices) - they should be rich men. What better way to make money than to know exactly about the absolute level of prices”.

“The problem is that, almost surely, expected returns vary through time because of risk aversion, wealth, everything else varies through time. But measuring that requires that you have a good variable for tracking (risk aversion) or good models for tracking it. We don’t have that”.

If understandably, you have not figured out yet, the additional quote would give you the answer:

Nobel laureate #1:

 “Well, Gene and I have a lot in common, more than you might think”.

Indeed, Eugene Fama and Robert Shiller may disagree on the need for the authorities to monitor asset valuations and regulate aggregate risk exposures. - However, they share a common view: regardless of how efficient the market is, nobody can systematically beat it, especially in the short run. So, no room for gurus within the bounds of licit information rules and practices. Just a tiny room for, both hard working and lucky, alpha seekers.

The case for active management is the main casualty of the above mentioned consensus. -  The paragraphs below offer a brief illustration using the Chilean pension fund system as a fresh case of the futility in advising active portfolio management.

The defined contribution´s pension system in Chile features five possible portfolios to choose from for both compulsory and voluntary savings of future pensioners. - Each portfolio allows for a different asset class composition: the riskiest, 80% max. held in stocks; the safest, 95% min. held  in money market, fixed income.- Although there are some restrictions to move into the riskiest funds to those near the age of retirement, the majority is free to move from one portfolio to another at a negligible fee.

Since 2012, concerns rise that an increasing number of contributors start to follow cheap advice from non-regulated investor counselors, the result being a boost in portfolio shifts and some subsequent disruptions in both stock and fixed income markets. 

As it turned out, the number of savers shifting to and from the riskiest pension portfolio peaked just during the days after specific recommendations were issued by a local ´guru´. Eventually, the authority issued further regulations to discourage market timing. 

Most interestingly, it was found out that six out of the eleven recommendations delivered by the referred ´expert´, proved wrong. - Indeed, that is slightly worse an outcome than failure chances when flipping a coin.

Others results came from research on pension affiliates’ moves from one fund to another between 2012-2013. - They did poorly. 

• Almost two thirds individuals ended up gaining less than the least profitable of the five existing funds (bought high, sold cheap).   
• As for the rest,  21% performed as well as one of the original portfolios and; 
•  Only 13% outperformed the most profitable among the five existing portfolios. 

Chile: effective annual returns to market timers in pension funds

(Real rates; ap. 2012-mar. 2013)

Real return bracket	Percentage of those who shift
Above the best existing passive portfolio	13.5%
Within range of existing portfolios [2.5%-4.1%]	21.6%
Below the worst existing passive portfolios	64.9%

Source: Superintendencia de Pensiones

Moreover, when following up on each individual original position, 77% of those who decided to move ended up worse off than not doing so.

Indeed, nowadays there is no need to be a Nobel disciple to learn that market timing is generally naïve, usually self-destructing.                                                     

www.juanfoxley.com

Settling for more

Central banks and FX risks

By Juan Foxley 

Posted at Financial Times Alphaville. A Spanish version published at América Economía.

Each day, an average of USD 5.3 trillion is traded in the FX markets. That is about 11 times equivalent to what primary dealers trade in US Treasuries at a given day and more than half a year trading value of listed stocks in the NYSE.

 

Being the largest market in the world is enough a reason for caring about safe settlement. Also known as “Herstatt Risk”, settlement risk may reflect in the loss of principal if one party to a FX transaction would deliver the currency it owes, but would not receive the bought currency from its counterparty.

Financial market regulators and some central banks gathered around the BIS have acknowledged settlement risk as the most significant system risk to participants in the FX market, accordingly began to provide recommendations and guidelines to mitigate it, also pushing authorities to do more:

" FX settlement-related risks have been mitigated by the implementation of payment-versus-payment (PVP) arrangements and the increasing use of close-out netting and collateralization.However, substantial FX settlement-related risks remain due to rapid growth in the FX trading market.…it is crucial that banks and their supervisors continue efforts to reduce or manage the risks arising from FX settlement. In particular, the efforts should concentrate on increasing the scope of currencies, products and counterparts that are eligible for settlement through PVP arrangements." Basel Committee on Banking Supervision (2012)

The main PVP arrangement is CLS – (Continuous Linked Settlement) -which is organized as a consortium of 63 banks, regulated by the Federal Reserve Bank of NY. - CLS operates a global multi-currency cash settlement system through which settlement risk is mitigated, using a combination of payment versus payment (PvP) settlement over CLS central bank accounts. These local currency payments are executed through local real time gross settlement (RTGS) systems with finality. Daily funding obligations are multilaterally netted to materially reduce the required pay-in values, which provide enhanced liquidity efficiencies for participants.

So far, USD 2.3 trillion -(settled volume divided by two)- is executed using the CLS infrastructure. That is, 43 percent of total FX world trading.

Unfortunately, not many central banks are joining CLS. Most notable exception is the Reserve Bank of New Zealand which is a shareholder member of CLS. Also, a few other central banks appear using CLS as third parties by contracting members´services: Colombia, Denmark , Hungary, Israel, Singapore, South Africa are among them.

One natural candidate for joining CLS would be Banco de Mexico. The MXN is already one of the 17 eligible within the multi-currency settlement system and, its domestic legal arrangements are in place for proper FX trade execution.

Other central banks missing from CLS are those issuing currencies which are exhibiting relatively high and increasing international liquidity  but are not yet part of the now 17-group. For example, China´s PBC and the central banks of Russia, Turkey and Brazil, among others.They would need to be proactive, twofold: in doing their legal and technical homework as it is required to win currency eligibility and, using themselves the CLS as the FX settlement vehicle. That would signal a commitment to system risk minimization while at the same time, duly protecting their international reserves against principal losses from Herstatt risk exposure.

www.juanfoxley.com

Aussies, Loonies and other central banks´friends

  A spanish version published in América Economía; 
english versions also available at Financial Times Alphaville and SimplyNoRisk

 ______________________________________________________________

"There is no sphere of human thought in which it is easier to show superficial cleverness and the appearance of wisdom than in discussing questions of currency and exchange".

The famous Churchill´s sentence, very much in place when it comes to guessing when one particular currency shall weaken or strengthen. What we do know better is that in minimizing the chance of capital losses from currency fluctuations, a well diversified portfolio continue to be the cheapest and foremost risk management tool. That, the old Markowitz corollary, is what central banks have gradually put in practice over recent years.

Non-reserve currencies are nowadays a much higher proportion of international reserves. This is especially the case of central banks in emerging and developing countries where recent turbulence has not obscured the main fact: the share of non-reserve currencies- (all but the four SDR components plus the Swiss Franc)- reached 8 percent of allocated reserves this year. As a proportion, this is about four times higher than in 2007. 

Leading the new currency friends are Australian aussies and Canadian loonies (about 1.6% each). Reflecting its importance, the IMF´s  COFER report recently began to publish them individually. Among central banks,it is also well known  that Norwegian, Swedish and Danish Kroner; Korean Won and off-shore Renminbis are following suit.

Higher currency diversification has been facilitated by the increased level of reserves itself.  They have raised well above adequacy level standards (i.e. months of imports, short term debt service, size over GDP). Therefore, a satiated liquidity tranche has unleashed higher degrees of freedom at the investment tranches. The case for holding net foreign exchange assets in US dollars-(and the other three composing the SDR basket, for  that matter)- weakened. More so when fundamentals remain fragile in most countries which issue anchor-currencies. No wonder, several central banks are known to hold CAD and AUD denominated assets (e.g. Brazil: 9.1 percent; Chile: 13 percent; among many others).

Interestingly, last 12 months performance of  those two popular non anchors disappoints. The AUD and CAD spot rates show 14 and 6 percent losses against the USD, respectively.

Are these AUD and CAD losses a reason to dismiss these new currency friends altogether? 
Of course, not.

The role of the newcomers is not to add capital gains but to cushion exchange rate volatility, hopefully bringing with them a dose of negative correlation to the returns on the currency portfolio. The Won and Euro appear to fulfill that role, gaining 3 and 6 percent, respectively.

Another way to evaluate performance and pursue asset allocation for investment tranches would focus on the local currency as the numeraire. This is becoming common practice among central banks that care for their status of independence and core capital preservation on their books. Even inflation adjusted domestic currency is utilized.

As an example, the figure below illustrates the case for Chile. When measured in local currency units, the AUD continued to be a drag but the CAD parity becomes Peso neutral, while Euro and Won holdings being a positive

Aussies and Loonies versus Euro and Won, against the Chilean Peso
(click to enlarge)

Would it be better to diversify away of AUD and CAD? 
May be. 
Empirically, nobody could be sure about observed variance-covariance patterns. Correlations may shift or even reverse over time. 
Conceptually however, the following asset allocation rule would be very much in order: a central bank from a commodity exporter country would be better hedged against currency risk when the value of its reserves would move opposite to commodity prices. Therefore, beyond liquidity considerations, Aussies - (among other so called commodity-currencies)- would not be best friends for central banks at commodity exporting countries. And good friends are needed to help you cope with pressures over your international reserves.

www.juanfoxley.com