Ramon Koss has an extensive background in trading, traditional and alternative investment management, asset and liability management, and product engineering. Before founding and taking charge of the Alternative Investment unit, Koss headed Credit Suisse Private Banking's Global Treasury and Trading, and Asset and Liability Management.
- The first half of 2004 has been difficult for many
hedge fund managers. Do investors need to review their expectations?
Yes. But it is important to differentiate between temporary swings in market conditions and longer term evolution. Some investors expect hedge funds to always provide positive returns. In reality, hedge funds are selective risk-takers, and are prone to underwater periods when taking such risks does not provide adequate returns.
- What special conditions have dominated market behaviour
We have seen a lot of uncertainty in the markets across asset classes. Typically, such periods are difficult for hedge funds. This should not be confused with negative periods for the stock or bond markets, where many alternative strategies can in fact do very well. The massive inflow of new money into absolute return strategies forces a re-evaluation of the role that alternatives, and especially some of the shorter-term and arbitrage strategies, are expected to play in a portfolio. This industry has not previously had to cope with capacity constraints across the board, and will have to adapt.
- What have been the main sources of new capital during
the last months?
Institutional investors have started to recognise the benefits of alternatives in terms of diversification and return potential. They have begun allocating serious amounts to alternative investment strategies. These investors are quite risk averse and prefer perceived low-risk strategies. As a consequence, strategies focusing on short-term arbitrage have become extremely crowded.
- Would you say arbitrage strategies in general are harder-hit
by the recent capital inflows than directional strategies?
Yes, directional strategies were hurt by the recent noise and abrupt reversals in the markets. Capital inflow has been a negative for shorter-term directional strategies' performance, but not for their medium- and longer-term counterparts, since capacity-related issues and market liquidity for such strategies are usually not dominant factors. Arbitrage strategies, on the other hand, are now at levels where clearly margins have eroded. In some instances, reverse strategies bear serious consideration. That of course typically implies a divergence-trade return profile, which many in this space currently still find difficult to accept. Nevertheless, the premium for such optionality is currently extremely attractive.
Do you think allocators feel that convergence strategies are of lesser risk? This may be the case at first glance. Certainly in regular market phases, you could say that. In the case of some convergence strategies, I would question whether they are really inherently of lower risk per se. We should not accept that a lack of historic short-term performance volatility is a good measure of strategy risk. Risk measures are based on probabilities, whether modelled on the past or on some assumptions, while risk-events are real occurrences. Once a major event has occurred, one generation of traders will be a little wiser, but not necessarily the next. And, unfortunately, strong capital inflow does not provide proper incentives for prudence in research nor money management. If you consider the increased leverage many arbitrage managers have to employ to keep their expected regular returns rolling in, you get a fair idea of what could happen if market conditions were to turn seriously sour
- Do you stay away from arbitrage strategies?
On the contrary, arbitrage strategies - and there are many of them - have great merits. I am saying that care has to be taken to understand what the exact risks of a specific investment are, where the risk-driving forces reside, and to consider outlier events when building portfolios. This seems obvious. But remember: there is a huge demand, partially for the wrong reasons and facilitated by wrong assumptions, for portfolios that look peaceful... But it does not pay to build a low-vol portfolio that goes down in a blaze when markets are shocked, just because of implicit or explicit leverage that seemed okay during normal times.
- Will the inflow end soon?
Not likely. Many pensions and endowments are adjusting their investment philosophy, away from tracking benchmarks, towards trying to match liabilities. For a while now, institutional investors have been opening up to alternative investments, and their asset base is huge. It takes a while to absorb this inflow and work it into the markets, and I have little doubt that a certain degradation of alpha quality - but not a loss of alpha generation altogether - will have to be accepted by investors.
- Do you see alternative investments losing their appeal?
Rational and reasonable expectations do not have to be adjusted. Within the context of most mixed portfolios, diversification benefits generated through investments in alternative strategies are not impacted. Exaggerated return expectations should be curbed.
- Have other factors played a role in hedge fund performance
so far in 2004?
Strongly heightened awareness of the potential impact of oil prices on the economy, just at a time when the U.S. and other countries seemed to be on the brink of sustainable recovery, has come as somewhat of a shock to many investors. Shocks cause uncertainty. In terms of market characteristics, uncertainty invariably expresses itself in a high degree of randomness.
- Like many market participants would you uphold the
idea that prices always behave in a random fashion?
I don't. Completely inconsistent with unbiased observation. While noise levels are certainly not stationary, and almost always very high, certain other attributes are also true. Maybe the simplest example is the overall positive serial correlation of price changes - true for almost all markets - a feature which has been profitably exploited for decades.
- Coming back to oil prices: why - outside of energy-related
investments - should oil prices influence hedge fund performance?
The problem does not lie in the absolute level of energy prices, which by the way is not high on an inflation-adjusted basis. Rather, the psychological impact of the sudden focus on oil was important. This is not the first time we have observed a strange market phenomenon following external events that have widespread impact: several weeks after such shock events, markets tend to slip into confusion. During such periods, short-term volatility gets more bloated compared to longer-term volatility, and many spread relationships become unstable. Short-term momentum does not translate into longer-term serial correlation. Discretionary investment managers stay out - usually after being burnt some - or take their stops more quickly. Often, this might also include a readiness to take profits earlier. When too many market participants behave like that, randomness becomes a self-fulfilling prophecy. In other words, market characteristics change, and many strategies become affected. Sharp break-outs are not uncommon, but do not lead to well-defined trends during such phases. The few trends you do see are usually interrupted by sharp reversals.
We believe that despite the abundance of non-discretionary strategies, market participants' psychology is a much stronger factor in all freely tradable markets than most would like to admit.
- Are you referring to alternative investments or markets
The latter. Let's be clear about one thing: alternative strategies plough the same markets as traditional investors. The means may be different and more encompassing, but markets are markets. Hedge fund performance is a function of strategy applied to these markets.
That is also why the whole debate about whether alternative investments are an asset class may not be very fruitful: we should rather ask ourselves whether hedge funds and their investment styles can diversify a portfolio. They diversify across multiple risk drivers, and their ability to act and react makes them asymmetric investments. But to me, the asset class debate is purely academic. I have to build portfolios.
- If market psychology really is a strong factor, what
about the hypothesis of efficient markets? You can hardly
argue that this is only held by a few.
You know, I look around and I don't see efficient markets. I see over and under reaction in the short-term, and I see a tug-of-war between fear-dominance and greed-dominance in the longer term. Directional investment strategies, for example, exploit nothing else. If markets were efficient you'd see one price for a while, then immediately after new information becomes available, a sudden jump to what is perceived as the new "fair" or "correct" price, followed by a narrow price distribution around that new price, until further information becomes available. Such behaviour can be observed in many markets from time to time, and, for some markets it is even quite typical. But in most markets, it is temporary in nature. In fact, it is mostly encountered during uncertain times. Any observer will see that in most markets it is not a stationary characteristic - never has been - nor predominant over time. My arguments in this respect are closely related to what I told you earlier about noise levels.
- You are implying that investors are not rational.
Perceptions alter, focus can shift, preferences change, new experiences are added. In my opinion, this is perfectly normal and does not constitute irrationality.
In addition, behaviour can only be rationalised within a certain frame of reference, call it calibration framework, or sample universe, or simply past experience. Under the assumption of stationarity of past conditions and preferences - or the ability to model the instability - you can design entirely rational systems, in trading or anywhere else. But again: "rational" only in the context of the past and of a probabilistic picture of the future.
- How long are the currently difficult market conditions
likely to last?
That's a hard call. Historically, such behaviour has often set in with a certain delay - typically a few weeks after a shock event - and the ensuing afterpains can last a few months. After 9/11, an unusual amount of 'noise' governed most markets from November 2001 until early April 2002. Currently, we are seeing a slow re-generation of short-term market patterns and a slight pick-up in intraday stock market ranges that would suggest a return to potentially easier market conditions during the course of this autumn. But the indications are weak so far, I'm afraid, and their predictive value is limited.
- Until recently, alternative investment strategies were
deemed rather esoteric by most investors. And to many, persistent
alpha generation still seems impossible.
Understandably so. Absolute return oriented investment managers claim to be able to beat the market reasonably consistently over the long run. As we already said, traditional financial theories and wisdom hold that this is not possible.
- But you and other proponents of hedge fund investments
claim the opposite is true.
Indeed, and the alternative industry can certainly boast good past results. But in fact only a minority of investment managers are proven survivors - at the expense of less successful investors.
- Speaking at various conferences, you have suggested
that a bifurcation of the alternative investment world is
imminent. Do you see further signs of such developments?
Clearly, alternatives are becoming more mainstream. Investors are offered investable alternative index products, and the general benchmarking mania has resulted in a deeply rooted belief amongst some investors that only a handful of rather pure alternative investment styles exist. These styles are viewed as though they were asset classes. Investment managers are coming under a strange sort of pressure which was previously unknown in the alternative investment community: that of performing like the 'relevant' benchmark. In order to deliver, you'd have to invest like the average benchmark contributor - a rather strange notion if you ask me, but in fact very real, if you look at what's happening around us.
By contrast, astute investment managers have always tried to find inefficiencies they can exploit profitably. The simple regurgitation of 'known' strategies by that large part of the industry which is going mainstream leads to new inefficiencies. Clever investment managers will be able to exploit these. We know quite a number of innovative people who are working on such new strategies. Mostly, they are concentrating on finding wrongly priced inter-market and inter-strategy relationships. We call it 'inter-silo-arbitrage', because you find these opportunities wherever whole groups of traders and other market participants lead secluded lives in their familiar box, instead of looking beyond their own asset class, or time-frame, or strategy dogma. Unfortunately, this sort of new arb opportunity can create a lot of transaction cost and slippage, especially in shorter time-frames, and sometimes cannot even be traded for simple lack of suitable instruments. So, one of the constraining factors is that you need the right financial instruments rather than a complex encapsulation of separate trades to lock in one investment idea. These derivative instruments are being created as demand rises.
- So you remain confident about the outlook of alternative investments?
As long as alternative managers remain eager searchers, and prudent in implementation, investment opportunities exist and money can be made.