Market Complacency

The risk of inaction

by Kostas Iordanidis, Co-Chief Investment Officer

Olympia Capital Management

It is a challenging task to express views on market complacency. Over the past half a
century, the foundations of finance theory have been built on the concept of Efficient
Markets, with market prices being the reflection of the collective information on the
prospective returns of financial assets. And yet despite academic orthodoxy, markets reflect
not only the fair value of risk premiums for financial assets at any point in time but also the
behavioral biases of market participants.

If we define complacency as the systematic miss-pricing of financial market risks by market

participants for extended periods of time, complacency is then the direct result of the
behavior of buyers and sellers in financial markets. The financial literature has identified and
analyzed numerous such biases, all of which are innate, in the sense that they stem from the
neurological hard wiring of the human brain. We are all familiar with investor focus on short
term performance, disregard of fundamentals and over-reaction to news etc. At the extreme,
such behavior leads to financial bubbles which do not necessarily require investor
irrationality in order to occur but they can happen even within in the framework of rational
expectations (see for example Charles Kindleberger’s excellent book “Manias, Panics and
Crashes: A History of Financial Crises”, Wiley 2005, 5th edition). Complacency is a
necessary precondition that leads to financial bubbles.

Is there a way to simply measure complacency in financial markets? Perhaps the simplest
measure is the level of option implied volatility of financial assets. We can think of implied
volatility as the sum of two components; a forecast of the future realized volatility of the
underlying financial asset and an insurance premium that serves as compensation for the
underwriter of the option (e.g. the floor trader or the investment bank).

The following chart shows the daily levels of the VIX Index (a measure of the implied
volatility of near term at-the-money S&P500 options) over the past seven years. As the chart
clearly demonstrates, equity implied volatility has declined precipitously over the past three
years to a level of approximately 10%, from an average level of 30% in the 2000-2002
period. It is also evident from the chart that the slightest indication of market turmoil is
enough for the VIX Index to spike upward. Indeed in June of 2006, with the equity market
selling off the VIX Index jumped to 24% from 11% in a few days.

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The low levels of equity implied volatility over the past three years are my no means unique.
As the following chart illustrates, equity volatility was at similar low levels in the 1992-1995
period. What is also clear from this chart is that over the past 20 years that we have equity
option data available, equity volatility has been at times significantly higher than current
levels and never below 10% on a sustained basis.

Long Term History of the VIX Index

60

55

50

45

40

35

30

25

20

15

10
Jan-86 Jul-87 Jan-89 Jul-90 Jan-92 Jul-93 Jan-95 Jul-96 Jan-98 Jul-99 Jan-01 Jul-02 Jan-04 Jul-05 Jan-07

Daily Average of VIX Index (close) Daily Average of VXO Index (S&P100, close)

An analysis of US Corporate spreads shows a similar pattern of complacency with respect to

credit risk. The following chart shows the spread between Baa rated US Corporate Bonds
and 10 year US treasury Bonds over the past 37 years (the data come from the Board of
Governors of the US Federal Reserve). Again after reaching historical highs in 2002 in the
aftermath of the Enron and WorldCom bankruptcies, credit spreads have declined
substantially to levels at which the risk premium offered for bearing credit risk is minimal.

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 Spread between Baa Corporate Bonds and 10yr US Treasuries

4.0%

3.5%

3.0%

2.5%

2.0%

1.5%

1.0%

0.5%

0.0%
Dec-69 Dec-74 Dec-79 Dec-84 Dec-89 Dec-94 Dec-99 Dec-04

In the case of credit spreads we have the benefit of having historical data for almost a
century. The following chart shows the spread between Baa and Aaa US Corporate Bonds
starting in 1919. Again financial markets are significantly discounting the risk of economic
distress and elevated levels of corporate bond defaults.

Spread between Baa and Aaa Corporate Bonds

6%

5%

4%

3%

2%

1%

0%
Jan-19 Jan-27 Jan-35 Jan-43 Jan-51 Jan-59 Jan-67 Jan-75 Jan-83 Jan-91 Jan-99 Jan-07

The third area of complacency in the market place is related to the behavior of hedge fund
managers over the past two years. One of the most important recent concerns of investors
regarding hedge fund investing has been the increase in correlation between hedge fund
returns and the equity markets. Indeed, over the past two years, the correlation between the
HFRI Fund of Funds Composite Index and the MSCI World Index has increased

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significantly, from a level that was close to zero in early 2004 to 0.81 in December 2006. The
increase in correlation between hedge funds and equity markets has naturally also affected
Olympia STAR I and our other diversified Fund of Funds (current correlation with the MSCI
World Index is at an all time high of 0.79).

One of the factors that have affected the correlation between diversified hedge funds like
Olympia Star I and equities is the significant increase in the correlation between Bi-
Directional managers (Global Macro and CTAs) and equity markets. This is not surprising
since most of these managers are trying to profit from trends in different asset classes. Their
large exposure to equities is related to the strong upward trend experienced by worldwide
equity markets since 2003.

The following figure plots the 3-year rolling correlations between the MSCI World Index our
universe of Global Macro managers, CTAs, and Credit managers between January 2004
and October 2006. The red-line – with scale on the right side of the figure – represents the 3-
year rolling volatility of the MSCI World Index over the same period of time.

1,00 20%

Equity market volatility starts

its decreasing trend 18%
0,80

16%
0,60
14%

0,40

MSCI World Volatility

12%
3 Y Correlation

0,20 10%

8%
0,00

6%
-0,20
4%

-0,40
2%

-0,60 0%
janv-04 avr-04 juil-04 oct-04 janv-05 avr-05 juil-05 oct-05 janv-06 avr-06 juil-06 oct-06

GLOBAL MACRO CTAs CREDIT MSCI World Volatility (Right axis)

The above figure vividly illustrates our conjecture on the origin of the increase in the
correlation between hedge funds and equities. First, we can see that the correlation of Credit
and Distressed managers that are not supposed to be highly correlated with equities has
started to increase just after the start of the downward trend in the MSCI World volatility. In
addition, as the credit cycle matured over the past three years and credit spreads tightened
significantly, managers in the space have been increasingly investing in post-reorganization
equities thus increasing their equity market exposure. Second, the historical correlations of
Bi-Directional managers have gone from negative in 2004 to highly positive. For example,
the correlation of Olympia’s Global Macro managers with equity was at 0.77 by the end of
October 2006. In an environment of diminishing opportunities in currencies and fixed
income, global macro managers have increased their exposure to equities and emerging
markets.

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In summary, we believe that the current level of complacency in financial markets is
significant, especially with respect to equity and credit risk and portfolio managers should
adjust their portfolios accordingly.

Furthermore, the extent of the increase in equity market exposure for certain managers in
our portfolio has been such that it could have a noticeable unintended impact to the overall
risk profile of our funds. Therefore we decided over the recent months to make some
changes in our diversified portfolios with the aim of decreasing the equity exposure of our
funds. We have implemented two important changes; first, at the strategy allocation level we
have increased our exposure to strategies that have a low correlation to equity markets.
Indeed, we have increased the relative allocation to Equity Market Neutral, Relative Value
and Quantitative Macro and decreased the allocation to Bi-Directional managers. Second at
the manager selection level, we have reviewed the list of all our managers across strategies
and decided to increase exposure, across all strategies, to managers that have exhibited low
correlation to equity markets.

With respect to Credit risk, we have maintained a defensive position by keeping the portfolio
allocation to credit related strategies relatively low and by focusing on investing with
managers that are themselves very defensive in the current environment. We plan to
maintain this stance until we see spreads at more attractive levels.

As a result of these changes we believe that our portfolios are better hedged with respect to
tail risk associated with significant equity market turmoil. At the same time, our funds retain
their ability to perform well in an environment of strong hedge fund returns. Based on our
analysis, we are confident that we will be able to reach our objective of reducing the equity
correlation of our funds, even if one has to bear in mind that each market crisis is different
from the preceding ones and is highly unpredictable.

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Kostas IORDANIDIS is co-chief investment officer at Olympia Capital Management in Paris,
where he is responsible for the management of the firm's fund of hedge funds portfolio.
Previously, Dr. IORDANIDIS was head of asset allocation at Julius Baer Asset Management
in Zurich. Additionally, he co-founded Z.I. Investments LLC, a global macro hedge fund, and
served as fixed-income portfolio manager at Lincoln Capital Management.

About Olympia Capital Management

Founded in 1989, Olympia Capital Management is an independent fund of hedge funds

manager with over $5.4 billion under management. The Group is 54% owned by its
management and 46% by Sagard, an independent Private Equity Fund. Olympia Capital
Management has an international presence, with over 80 people in Paris, New York,
London, Zurich and Hong Kong and an experienced investment team composed of 20
professionals with 10 years of experience on average. In addition to its flagship fund,
Olympia Star I with a 16 year track record, Olympia offers to investors a large range of
alternative multi manager funds: both multi-strategy and thematic, as well as customized
and sub-advisory portfolios.

For more information, see: www.olympiagroup.com

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