Fund Manager Skills There are several analytical techniques that a fund manager can use to protect the return on his investments. The first is called switching. When the fund is not performing, the fund manager uses available market information and his skills to restructure his portfolio by selling some positions and replacing them (switching) with assets which have better prospects. In most cases, the amount of turnover in a fund is either restricted by regulation or by the tax implications of the fund. The second technique is called immunisation – and is typically used in fixed income portfolios, where for example, the fund manager sets the duration of a portfolio to equal the longest period over which he can predict events.
Attributes of Institutions
It is important to recognise the differences between institutions because the objectives of the institution will be a large factor in determining the goals and how they go about achieving them. Institutions can differ greatly, although the majority of financial institutions, such as Building Societies and Banks, have common attributes.
Revenues Institutions earn revenues and therefore can generate profits in a number of different ways: + Market makers make a profit through the “turn” – that is, the difference between their bid and ask prices on any instrument. + Traders make a profit though their skill in determining when and at what price to buy and sell. + Brokers earn their revenues by charging commission on trades they complete for their clients – the “fills”. + Fund managers earn fees, which in most cases are based on return or risk performance. + Investment banks earn fees for underwriting new issues.
Business Objectives All organisations or institutions develop and try to meet business objectives that steer the activities of the organisation towards the achievement of certain goals. Some common objectives are to: + satisfy customers and develop a good business relationship with them + increase earnings per share + increase market share + reduce costs + expand into new developments.
In order to meet these objectives, institutions must perform these activities: + trading + sales activities + cash flow management + asset management + risk management.
Trading Trading involves taking a position. A position is held when there is an imbalance between the sales and the purchases of an instrument. When there are more purchases than sales of an instrument the position is said to be long. When there are more sales than purchases the position is said to be short.
Sales Activities The sales role is the customer-facing one in most security houses. The role of sales is to drum up business with clients, private clients, corporate clients or fund management companies. In security houses that also perform proprietary trading or market-making, the security house must be careful not to off-load unattractive positions onto unsuspecting clients. The new tighter regulatory structure is intended to minimise this practice. Many institutions offer to buy or sell financial instruments on behalf of other institutions, for commission. An example is a bank which buys foreign currency such as Deutschmarks on behalf of a corporate treasurer. This activity will leave both institutions with a position in the market since the bank will be short on Deutschmarks and the corporate treasury will be long on Deutschmarks. The institution usually hedges this position.
Cash Flow Management Large organisations often have temporary cash surpluses or deficits in their domestic currency or foreign currency. These need to be managed by making deposits or loans. An example of where cash flow management may be required is pension or insurance claims in an investment management institution. If a company does not have sufficient funds to cover the cash requirement, it may arrange a loan to cover the shortfall.
Asset Management Asset allocation accounts for a significant number of the tasks of many players in the financial markets, especially portfolio and fund managers. The aim of asset allocation is to select the assets in which to invest, for a stipulated risk and return, subject to a variety of constraints, for example, “no more than x% of the fund must be invested in emerging markets” or “at least 20% of the fund must be cash” etc. Asset allocation is important, as the user will want to browse through and search for the available instruments that fall within the constraints and meet the objectives of the business.
Risk Management Most financial institutions hold positions in the financial markets, and are therefore exposed to a number of different types of risk. Risk is the probability that a loss may occur due to an unforeseen development in the market. Risk management is a term used to cover all the tools and strategies managers use to minimise risk and avoid a possible financial loss on a position. It is important to note that there are various types of risk, for example, market risk, counterparty, or settlement, risk. Hedging is a strategy used to manage market risk by using one position to offset another. Different types of instruments can be used to hedge, such as forwards, options and futures. These instruments allow the investor to limit market risk.
Limits Limits are net amounts which define the range within which an institution or trader can trade. These are set by the institutions management in order to manage risk. A trader who reaches his limit must get authorisation from his manager if he intends to exceed that limit. A trader’s limit increases as his experience and responsibilities increase.
The following table illustrates how the strategy used depends upon the type of risk to be managed:
Risk Type Management Strategies
Credit Risk/CounterParty Risk The exposure to counterparties defaulting on a payments due, such as a bank becoming insolvent. Set counter party limits.
Country Risk/Sovereign Risk The total exposure of investments in a particular country. Possible problems could include economic collapse, changes to local regulations or government seizing or freezing assets. Set country limits.
Currency Risk The potential losses due to adverse movements in exchange rates. Setting limits on traders and desks exposed to a particular currency, and hedging large positions with derivatives.
Inflation Risk Associated with the return on an investment being eroded by the loss of purchasing power. Investing in inflation-linked investments such as Gold or index-linked bonds.
Market Risk The risk associated with losses due to the reduced value of investments, reduced income or increased costs due to interest rate movements. Hedge, plus limits, plus capital adequacy constraints
Liquidity Risk The risk of not being able to purchase or sell an instrument at the times desired. Only participate in liquid markets.
Settlement Risk The risk of a counterparty not settling on time. If the counterparty settles late, this means you either have a long or short position until the deal is settled. Dealing with reputable market participants, and using efficient settlement procedures. Bilateral limits. Netting.
Roles within Markets
This section defines the roles in the markets and details the activities they are involved in and the type of information they require.
Traders
What do Traders do? Traders buy and sell in all areas of the financial market. They aim to buy low and sell high. Trading may take place at physical exchanges, for example, for commodities or futures, or over the counter (OTC), for example, in foreign exchange. A trader may specialise in a particular type of financial instrument and different types of traders have different roles and requirements depending on the instruments they trade in. A trader who has gained responsibility in his career for managing a group of traders may be classed as a chief trader. The chief trader sets the credit limit for each trader and ensures that at the end of the day, all his traders are not long or short, that is, their buy and sell deals balance.
What is Order Driven Trading? If a trader is buying or selling instruments to fulfil an order for a customer, it is said to be order-driven trading. To avoid potential confusion with another meaning of this term, it is best to refer to this type of trading as “customer-driven trading” to distinguish it from “proprietary trading. It is important to note that order-driven and quote-driven trading in the markets are also used to describe different types of trading markets. For example, the old Seaq Level II and also NASDAQ are quote-driven markets, in which market-makers quote firm two-way prices and sizes. The new UK equity market Sequent 6 and Reuters Dealing 2000-2 matching are both examples of order-driven markets.
What is a Proprietary Trader? If a trader takes positions on behalf of his institution, he is known as a proprietary trader. Proprietary traders tend to take decisions based on detailed technical and fundamental research, analytic calculations and time series forecasting. In most cases, the tools available to the proprietary traders are developed in-house and are jealously guarded.
What is Arbitrage Trading? Arbitrage trading involves the buying and selling of the same or similar instruments in different markets in order to take advantage of any misalignment in the relationships between these instruments. The arbitrageur makes a profit when the relationships are restored. For example, a currency options trader who believes that the put-call parity relationship between a call, a put, and the DEM underlying on the IMM may execute an arbitrage strategy whereby he will buy the call and sell the put, or vice-versa, depending on his view of the misalignment.
What information do they need? Traders require real time prices for the market in which they trade, plus any supporting technical analyses and related news. However, because of the relationships between various instruments, they may also look at information from markets that they do not directly trade. For example, an equities trader may look at foreign exchange rates, deposit rates, bond prices and yields.
Fund Managers
What do Fund Managers do? Fund managers may invest funds for themselves or on behalf of their customers. Fund managers deal within the FX and money, fixed income and equities markets. An individual fund manager may specialise in a given market, or country, or region, or currency. They generally manage medium to long term investments such as pension funds, insurance funds, investment trusts or unit trusts.
What information do they need? Fund Managers require information on markets in which they directly invest. However, they also look closely at interest rates, foreign exchange, bond and equity data for any trends that may affect their investment strategy.
Corporate Treasurers
What do Corporate Treasurers do? Corporate Treasurers work within the FX and money markets, as part of a treasury department within an institution. Their main functions are to manage the institution’s day to day cash, invest cash surpluses, and borrow funds at minimum costs to the institution.
What information do they need? Corporate Treasurers require information on interest rates, foreign exchange, bond and equity data as well as forward and deposit rates. They also require the cash flow status of the institution they work for.
Brokers
What do Brokers do? Brokers mediate between buyers and sellers which means, in practice, customers and traders. Brokers also mediate between dealers or market makers – in which case they are referred to as inter-dealer brokers. They operate in the foreign exchange, bond and equity markets and usually work for independent brokerage companies. The main means of communication between brokers and clients is the phone. Most brokers have a constant live telephone connection with a number of dealers to increase the chance of obtaining best deal for their clients in terms of price and speed. Brokers earn commission on the deals they arrange. Brokers are agents. They are not principals and as such they do not normally manage a position, namely own equities, currency or other instruments, in the market in which they trade. Brokers have to be in touch with the market and be aware of developments so they can talk knowledgeably to customers when they ring.
Agency Broker Agency brokers buy or sell instruments on behalf of their customers on the buy side of the market. As brokers, they earn their living by charging a commission or brokerage fee for this service.
Inter-Dealer Broker Inter-Dealer Brokers match buys and sellers on the sell side of the market. They ensure that traders can trade with each other anonymously.
Brokers also need to create interest in the relevant instruments to persuade their customers to do business with them and to attract new business. By virtue of the fact that brokers are in constant touch with the market, they have access to the latest dealable prices. A number of the bigger brokers assemble these prices into a price service for their clients. For example, money brokers such as Tradition, Tullett and Tokyo, Harlow Butler all have price services distributed by various vendors on their behalf.
What information do they need? Brokers require the same type of information as traders. a money broker requires foreign exchange rates, bank deposit rates, bond data, graphical analysis and news information, as does a money trader.
Sales
What do Sales staff do? Sales staff take orders from customers to buy and sell instruments and act as an intermediary between customers and traders. Sales staff function in all markets. In equity and commodity markets, sales staff may also be known as brokers. Their customers are often institutional investors and they work for investment banks and agency brokerage houses. However, sales staff differ from traditional brokerage in that their institutions can hold a position in the market.
What information do they need? The sales function exists in all markets. In equity and commodity markets, sales staff may also be known as brokers. Sales staff may use the same information as brokers, depending on the instruments they specialise in. This includes foreign exchange rates, bond and equity data, other market prices, graphical analysis and news information. They use any information they can to build relationships with customers.
Decision Management
What is Decision Management? The term decision management describes the function performed by: + economists + analysts + researchers.
These groups of people forecast economic performance and market movements to provide guidance to traders and sales staff. They may also publish their forecasts, for a fee, to a wider market audience.
What information do they need? Decision management exists in all markets and financial institutions. Those engaged in decision management require price information, access to large quantities of historical data, spreadsheet and graphical analysis and notification of impending financial events and announcements.
General Management
What is General Management? The term general management describes the function performed by the following groups of people: + those from dealing room manager upwards, who may be active in the day-to-day trading operation + those in corporate finance, mergers and acquisitions + managers in a variety of roles in non-financial companies who are users of limited financial information and news information.
What information do they need? Managers may require historic and current information about companies in their sector or areas of interest. They also require basic foreign exchange information for the countries in which they operate.
Trader Support
What is Trader Support? Trader support can be split into two distinct roles: + position keeping, assisting traders in the dealing room + order entry, a book-keeping role in the back office of financial institutions.
What information do they need? Those who work in trader support roles require well developed operation skills and the patience to deal with traders in a hurry. They also need to have a general view of the financial marketplace.
Back Office Support
What is the Back Office? The back office is where the administrative tasks connected with dealing are performed. The back office staff are responsible for clearing, settlement, consolidation, integration with accounting, and so on. They also perform credit control and statutory and management accounting.
What information do they need? In addition to deal ticket flow, the information they require is mostly internal – credit limits, ledgers, etc.
International Considerations
Although the financial markets are becoming increasingly global, each country has its own currency and laws, taxation and other nuances such as number of currency days per year, bond yield calculation conventions, and so on. Considerations for internationalisation of software products, in addition to language issues, should be given during the design and development of products.
Since the FX market is an international market, all the standards, rules and regulations are in place to ensure smooth running of the market. All businesses, regardless of size, must register within the appropriate bodies before they can trade in the market. By registering, the business must agree to adhere to any guidelines laid down by the regulatory authorities.