(Bloomberg View) --
Today’s traders and portfolio managers -- self-described Masters of the Universe -- have hardly covered themselves in glory recently. Their surprise and initial panic at the Brexit result doesn’t say much for the extraordinary foresight, skill at managing risk and large pay packages many of them claim.
Truth is, whatever successes they’ve notched till now probably owed more to specific economic conditions than to their talent and brains.
Trading can be broken down into a few fairly simple strategies. Flow trading entails taking positions on the back of customer orders. Buying-and-selling patterns create opportunities for traders to exploit small price changes. Large, dominant dealers that participate in a high proportion of activity are especially well-positioned to benefit.
Proprietary trading and investing requires anticipating events and exploiting them. Economic and financial analysis and quantitative tools help to identify opportunities, giving this strategy the sheen of sophisticated science. But in fact, few manage to succeed at it consistently over long periods.
When economic conditions are stable, traders can resort to the carry trade: purchasing a high-yielding asset and financing it at a lower cost. Traders can also sell options (insurance) and bank the premium, assuming that they’ll never have to pay out.
During more volatile periods, traders can take advantage of mean reversion. If something has fallen or risen after an external shock, then you buy or sell it assuming that the value will revert to a long-run average. A subtler version of this strategy exploits correlation. If something tends to move in a particular way relative to something else, and then the relationship breaks down, traders assume parity will eventually be restored.
Traders also provide warehousing capability, allowing other participants to buy and sell at a price of the trader’s choosing. This price is set either high or low relative to where it’s likely to return when stability is restored, thus providing the trader’s profit.
Unfortunately, for several reasons, these tried-and-tested approaches no longer guarantee easy returns.
For one thing, the trading environment has changed. Low growth and subdued economic conditions mean that client volumes are patchy.
At the same time, unorthodox monetary policies such as quantitative easing and zero or negative interest rates are influencing values much more heavily than in the past. Massive central bank purchases of financial assets and currencies -- rather than market demand or fundamental economic principles -- are dictating prices and distorting risk-return relationships. Artificially low interest rates are propping up real estate prices. Capital fleeing low or negative returns in advanced economies has flooded into emerging market assets, inflating their value.
Trading prospers when returns are reasonably predictable. Today, heavy-handed central bank actions are producing long periods of stability, followed by large run-ups or meltdowns. When conditions are calm, traders are driven to buy risky assets in search of returns. But then they flee to safety at the first sign of instability. In suppressing volatility, authorities are thus ensuring large fluctuations when policies change or prove ineffective.
The result is uneconomic prices, increased volatility and disturbed relationships. Since 2009, asset correlations have changed significantly: Now, disparate investments -- such as bonds and stocks -- behave similarly whether in “risk on” or “risk off” periods, undermining the traditional benefits of diversification. Traders must anticipate regime shifts, where entire pricing relationships such as those between interest rates, currencies and asset prices, are rapidly redefined.
QuickTake Capital Requirements
Changes in market structure are making these problems worse. Modern risk modelling estimates potential future losses based on recent volatility. Market shocks translate into immediately higher risk measures and therefore larger capital requirements on trading positions; that means when price dislocations are largest and opportunities greatest, traders ironically have less room to buy and sell. Industry consolidation, regulatory changes and greater risk aversion have all contributed to a decline in trading liquidity in many markets, making it harder to enter and exit positions, especially big ones.
Finally, behavioral elements are complicating trading. Traders are no less prone than anyone else to groupthink. Taking the consensus view and losing means that you were wrong. Taking the contrarian view means that if you’re wrong, you also end up unemployed.
By this point, it’s getting harder and harder to discover new strategies that haven’t already been exploited by others. Faced with limited opportunities, investors all concentrate on similar trades, limiting their potential profits. This leads to crowding, where traders with identical portfolios find themselves unable to adjust positions when conditions change and thus suffer losses.
The factors driving markets today are complex and interrelated; specialized traders and asset managers operating within silos may not be able to spot opportunities and properly gauge risk. Increasingly, markets are also driven by political rather than economic or financial factors. Contemporary traders may be unequipped to deal with changeable social and political dynamics and outcomes at odds with finance textbooks. Few MBAs and quants would satisfy Siegmund Warburg’s requirement that bankers should be able to discuss politics, philosophy and literature as well as markets.
The fright that seems to have seized traders in the aftermath of Brexit is a sign of how much harder their jobs have gotten. But it also points to a more fundamental problem. Value dynamics and pricing mechanisms have become distorted, perhaps permanently, by policies originally designed to protect markets.
This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.