Currency of Change

Alpha Magazine
November 20, 2007

A top currency trader in the '80s, Bill Lipschutz now looks to capitalize on investors' appetite for foreign exchange.

by Frances Denmark

Bill Lipschutz is obsessed with trading. Not content with the conventional world of stocks and bonds, Lipschutz seized upon the currency markets early in his career and never let go. After rising to fame during the 1980s as one of the architects and then head of the global foreign exchange desk at Salomon Brothers, he is now principal of his own currency trading firm, Hathersage Capital Management. Lipschutz's trading acumen has earned him a profile in Jack Schwager's book The New Market Wizards: Conversations With America's Top Traders (1992).

Ironically, U.S. pension and endowment investors don't share Lipschutz's passion for foreign exchange — the biggest, most liquid, most transparent market there is. But if institutions have been slow to catch on to the alpha-generating potential of currency trading, Lipschutz predicts that is about to change.

"There are very sophisticated investors who are not there yet," he admits. "Any large institutional investor is going to be equity-centric. They think of currency management as a way of mitigating the risk of owning non-base-currency assets."

Unsure whether foreign exchange trading returns are the result of skill or luck, investors with an equity mind-set have long been suspicious of currency as an asset class. In the past few years, though, the tide has turned, as investment consultants have expanded their searches on behalf of a growing number of alpha-seeking pension clients. But the real avalanche of new assets will come from giant sovereign wealth funds in China, the Middle East and Russia, says Lipschutz, who is gearing up to receive them. China's sovereign fund alone is growing by $25 billion a month, he adds.

Since 1990, Lipschutz has traded from his home office in a duplex in New York's Greenwich Village. Four huge Macintosh computer screens sit atop a modern desk planted at one end of his architecturally designed workspace, which was featured in a 1999 exhibit at the city's Museum of Modern Art. But this office is also an elegant living space, as befits a man for whom work and life are inseparable. Lipschutz shares the apartment with his wife, Lynnelle Jones, Hathersage's director of client services and new product development.

Lipschutz, 53, didn't set out to be a trader. While pursuing a BFA in architectural design at Cornell University, the native of Farmingdale, New York, got interested in the markets after he inherited a stock portfolio from his grandmother. Lipschutz learned to trade equity options in 1981, when he landed a summer internship at New York based Salomon Brothers. After receiving an MBA in finance from Cornell's Johnson Graduate School of Management in 1982, he joined the firm and was given a desk 20 feet from then-chairman John Gutfreund.

For the new recruit it turned out to be the right place at the right time. Salomon was about to launch a currency trading operation, and soon afterward the Philadelphia Stock Exchange started listing currency options. Because of his facility with options, Lipschutz was tapped to help set up and build the new currency trading desk. By 1985, Salomon had garnered close to 80 percent of the open contracts in currency options and 50 percent of the volume on the Philadelphia exchange. "The product exploded in terms of volume and popularity," he recalls, "and it was my baby."

Lipschutz proved adept at forming the relationships -- and vital information flows -- that are the lifeblood of a discretionary currency trader. In the pre-PC, pre-Bloomberg 1980s, he and most of his peers relied on their own judgment to winnow trading ideas from the constant stream of macroeconomic and microeconomic data. Today discretionary traders like Lipschutz are in the minority. About two thirds of currency traders are systematic, meaning that they depend on quantitative models.

An over-the-counter, round-the-clock business, the global foreign exchange market has a capitalization that almost defies measurement. The Bank for International Settlements -- the central banks' central bank, headquartered in Basel, Switzerland -- records annual daily currency turnover. In April 2007 it calculated that an average of $3.21 trillion in currency traded each day, up from $1.88 trillion in 2004.

Currency traders transact deals through banking relationships rather than on an exchange. They can buy currency outright or through various derivative strategies -- using forwards or options, for example. Currency trading is a relative-value strategy in which a long-short pair is purchased as a unit, with one bought and the other sold. The popular "carry trade" involves pairing a currency from a low-interest-rate country like Japan (sell) with one from a high-interest-rate country like Australia (buy), in an attempt to earn the interest-rate differential. The ability to benefit from these differentials is one of the lures for new investors, Lipschutz says.

With $250 million in assets under management at Hathersage, Lipschutz is hoping to capture a portion of the new money he sees heading into active currency management. Such investment consulting firms as London's Mercer Investment Consulting, Russell Investment Group of Tacoma, Washington, and Arlington, Virginia based Watson Wyatt Worldwide have been vetting Hathersage. The eight-member firm has a client service office in South Norwalk, Connecticut, and a portfolio manager in Los Angeles. Hathersage is opening a New York based dedicated trading office in early 2008.

From January 1992 to September 2007, Hathersage racked up an average annual return of 17.95 percent in its short-to-intermediate-term fund and 12.32 percent in its short-term fund. During the same time the Parker FX index had an average annualized return of 6.41 percent, and the Parker discretionary index returned 6.38 percent. Both indexes are maintained by Stamford, Connecticut-based Parker Global Strategies.

Industry experts differ on currency managers' prospects. In 39 searches during the past two years, Mercer has placed $11 billion in client assets with active currency managers. "Because of the weak equity markets in 2003 and 2004, people were looking for anything that would add value," says Michael Lewis, a Toronto-based consultant with Mercer. "At that time currency had good returns and good information ratios."

Cynthia Steer is chief research strategist at RogersCasey, a Darien, Connecticut based investment solutions firm with some $325 billion in assets under advisement. She believes that with inflation expected to increase and currency valuations undergoing major shifts that are affecting country valuations, the need for currency investing is urgent. "Currency seems to be an issue that American institutional investors do not want to embrace," Steer says. "If they don't start to attack this issue through the committee and investment process, they will be severely penalized."

Short-term funds like the one at Hathersage have taken their own punishment from the recent market volatility. The fund was down 1.35 percent this year through the end of September, while Parker's index of discretionary currency traders eked out a 1.89 percent return. Still, Hathersage's intermediate-term fund gained 8.90 percent during the same period.

Lipschutz took a short break from trading on a recent Friday evening to discuss the outlook for the currency markets with Alpha Senior Writer Frances Denmark.

 
Alpha: What is causing growth in foreign exchange trading?

Bill Lipschutz: The entry into the market of several new and very large institutional players. You've got central banks of trade-surplus nations, such as China, Russia and the OPEC members, as well as sovereign wealth funds chasing higher returns through non-dollar-denominated offshore investment. At the same time, pensions and endowments want to segregate and actively manage the currency component of their non-base-currency assets, and global macro hedge funds are looking to put money to work in the enormously liquid currency markets.

 
Which currencies do you trade?

We only trade G-10 currencies, because they are the most continuously liquid, both in spot and in options. Australia, Japan and the Eurozone have transparent, stable and well-flagged economic and political policies. Emerging-market economies are often more opaque and less stable.

 
Why do you use options to trade foreign exchange?

We generally buy options and combinations of options to express basic trade ideas and build basic positions. This approach offers superior risk-return characteristics to buying the actual currency pair or spot -- also called cash -- outright. It also has a built-in risk management system; you can lose only what you put up. As well, there are often pricing inefficiencies in the options themselves that we can profit from.

 
What governs your investment process?

We are primarily directional in nature. While we look to positions based on a view of one currency's appreciating or depreciating against another, we are constantly seeking fundamental bases for a currency pair to move. As a user of long options, we are generally long volatility as well. We will profit from instability. Often we are positioned not for a move up or down, but for a move in either direction.

 
Where do your trading ideas come from?

We are discretionary traders, which means we develop two views of the world. The first is a macro view -- the big picture. We absorb all kinds of information regarding world events, macroeconomic factors and global political developments. We also look at the micro environment, called "being close to the market." We work the phones day and night; we talk to traders, salespeople and economists at major banks and to other hedge funds. At all times we want to know what the market drivers are -- what's moving a currency pair?

 
What is driving the currency market now?

The currency market is focused on global imbalances, and with the Federal Reserve Board aggressively cutting interest rates in response to the still-unknown effects of the credit dislocations of the past several months, the market is in full dollar-sell mode. But the wrinkle is that those unknowns have also inspired higher volatility across all asset markets and a heightened sensitivity to risk aversion. As a result, some currency market participants are less eager to hold carry trades and are selling high-yielders, such as the Aussie dollar and the Kiwi dollar.

 
How do you manage rapid market change?

Often there is an advantage to being a discretionary trader. We can move more nimbly when things change rapidly. We are very quick to see market sentiment shift and are primed to take immediate action.

 
What has been the impact of the recent equity market turmoil on foreign exchange trading?

Global stock markets have recently been looked to as indicators of global markets participants' willingness to take on risk. When these markets are under pressure, currency traders tend to want to cut riskier positions, such as the carry trade.

 
What factors are triggering risk aversion?

Many global stock markets are near all-time highs, while the U.S. housing market is collapsing, mortgage lenders are going bankrupt and banking institutions around the world are writing down billions of dollars' worth of asset-backed paper. This is not a stable situation. In this environment, many investors are simply cutting back on exposure and moving to cash.

 
How do general financial worries affect currencies?

Currency traders are aware of the heightened uncertainty surrounding unknowns such as the extent of the credit problems in the U.S. and other countries. They also understand that any new headline could cause an abrupt change in market sentiment, and they're ready to commit huge amounts of capital almost instantaneously in response to such information.

 
How do these rumors influence your trading?

In a nervous macro environment, headlines and rumors take on a life of their own. As the market absorbs information, large currency moves may be generated. This in turn can force the hands of participants holding what have now become the wrong positions, even if they believe the new information is false or unimportant. In such cases the market will reduce risk exposure by nonselectively cutting positions.

 
Why has the U.S. dollar been falling?

The official line from the U.S. Treasury is that a strong dollar is in the best interest of the U.S. and that FX rates should be set in a free and open market. Although that has been the mantra of the U.S. Treasury since Robert Rubin took charge during the Clinton administration, most players believe that the past two administrations have in fact favored an unstated policy of dollar depreciation.

 
Why has the U.S. adopted what is in effect a policy of benign neglect?

A lower dollar makes imports more expensive and induces people outside the U.S. to consume U.S. production, which tends to narrow the trade deficit, one of the global imbalances that the finance ministers of the G-7 have targeted. It's Economics 101.

 
How do the G-7 meetings guide currency trading?

At the end of each G-7 meeting, an official communiqué is issued. It typically describes the concerns of the ministers with regard to global economic issues. As with any official release, the market looks for deviation from past views or past language -- from information that is already built into market prices. When markets are nervous, as they have been since the middle of the summer, these meetings take on even greater importance. As late as the Friday afternoon before a typical weekend meeting, currency markets can be unusually active as traders make last-minute adjustments to their positions based on early indications of potential changes in the ministers' focus.

 
How much power do the G-7 finance ministers have to bring about change?

These days there's nothing likely to come out of the G-7 in terms of coordinated changes to monetary or fiscal policy, or market intervention. Nonetheless, markets do tend to react to official comments. There's always a lot of buzz surrounding the ministers' discussions, and the market looks for both explicit intention and nuance in their pronouncements, much as Fed watchers hang on Alan Greenspan's or Ben Bernanke's every word.

 
How does monetary policy affect your trading?

Policy per se is perhaps less important than understanding how to proceed if the market perceives that monetary policy is changing. My team doesn't try to outguess the Fed or the Fed watchers. We operate in the currencies of developed economies, stay abreast of market positioning, practice solid risk management and try to assess at all times how the rest of the market sees the world.

 
Will the current market turmoil have a long-term effect on the currency market?

There is still new money, big money, coming into the sector. I see that continuing for some time to come.