The Emerging Role of Crisis Alpha Investing

Kathryn M. Kaminski, PhD CIO and Founder Alpha K Capital Visiting Lecturer Stockholm School of Economics Visiting Lecturer MIT Sloan School of Management

Adaptive Markets Hypothesis

The Adaptive Markets Hypothesis (AMH) (Lo 2004, 2005, 2006) is an approach for understanding how markets evolve, how opportunities occur, and how market players succeed or fail based on principles in evolutionary biology. Markets dynamics are governed via the forces of:
Competition Mutation Adaptation Reproduction

The Modern Market Ecology

Prices reflect as much information as dictated by the combination of environmental conditions and the number and nature of species in the economy, or, ecology. Species are defined as distinct groups of market participants: ex: pension funds, retail investors, hedge funds. Andrew W. Lo, 2004

Opportunities and Competition

According to the AMH, profit opportunities exist when more resources are present and competition is lower. As competition increases, by natural selection those species or market players who can mutate, adapt and develop a competitive advantage over others survive. This process reduces competition and the cycle starts all over again. Example: The waxing and waning of hedge fund styles over time.

Who Wins?
It is precisely the market players who apply the best investment heuristics, those which are able to effectively adapt and compete, who outperform other market participants and survive to continue to compete. Survival of the Richest Andrew W. Lo, Harvard Business Review, March 2006.

Adaptive Heuristics
Humans beings are not optimizers -we adapt and apply heuristics to make decisions (this includes financial decisions). We modify our heuristics over time as we learn, the environment changes, and we gain experience. Example:10 pairs of pants, 17 shirts, 8 belts, 13 ties, 14 jackets, and 10 pairs of socks 2,475,200 different combinations at 1 second per outfit a total of 28.648 days Question: How did you make it to work today?

Equity Market Crisis

When equities go down: Most investors have a long equity bias (including hedge fund investors) and as such they are effectively driven to action Most investments have specific drawdown, de-gearing and risk limits (VaR) which are triggered by losses and volatility Equity markets are often the driver for trends in other markets (e.g. flight-to-safety in bond markets) Equity crisis scenarios represent times where large groups of investors are forced and/or driven into action.
Source: Kaminski, K. 2011

Crisis Alpha Opportunities

When investors are forced or driven into action: liquidity disappears fundamental valuation becomes less relevant large groups of investors flee from some asset classes and herd into others desperately seeking liquidity and safe assets This creates predictable trends across a wide range of asset classes. According to the AMH, when the financial environment changes, in a market environment where the vast majority of investors are polarized in their actions, very few market players will be competitive. The select (few) market players who are more adaptable during these moments can take advantage of the predictability across all markets earning crisis alpha opportunities.
Source: Kaminski, K. 2011

Case Study: Managed Futures

Managed Futures invest in futures markets via professional money managers: Commodity Trading Advisors (CTAs). Futures Markets Liquid Transparent Reduced counter-party Directional: The strategies exploit directional risk moves in futures markets prices upwards or Regulated downwards. No asymmetry between long and short Globally diversified: Trade both long or short Cover a diverse range of contracts in FX, interest rates, stock indices, asset classes energy, metals and soft commodities in regulated and interbank markets worldwide. Regulated: Managers are typically authorized and regulated by financial supervisory authorities, such as the FSA in the UK, the Commodity Futures Trading Commission (CFTC) and the National Futures Association (NFA) in the US.

In Search of Crisis Alpha

Managed Futures Highly liquid trading strategies with minimal credit risk trading exclusively in futures markets Systematic, void of long equity bias Less susceptible to the illiquidity and credit traps that most investors experience during equity market crisis Less susceptible to behavioral biases and emotional based decision making Poised to profit from trends across a wide range of asset classes

Active across a wide range of asset classes

Decomposing Crisis Alpha

Source: Kaminski, K. 2011

Crisis Alpha and Barclay CTA

Source: Kaminski, K. 2011

Crisis Alpha by Sector

Futures markets are some of the most efficient markets. Players who trade exclusively in these markets can trade more efficiently than others and thus take advantage of crisis alpha opportunities across a wide range of asset classes.

Source: Kaminski, K. 2011

The New Normal?

The Modern Market Environment Increasing globalization of financial markets Increased level of integration across financial markets Increased push for further financial regulation Accelerating speed of information transfer
Source: Kaminski, K., SFO Magazine, July 2011.

The Result Increased cointegration of financial markets Lack of diversification Potential for increased coordination in market participants via complex counterparty networks New regulations may simply lead to further coordination of market participants

Send in the Tails

Recent research in hedge funds during crisis has demonstrated that many hedge funds are holding common latent idiosyncratic risks in credit, liquidity, and volatility. (Billio, Getmansky, and Pelizzon 2010) Many risks are not measurable using traditional methods Complex interconnected networks of counterparties can create hidden commonalities in risk factors Complex funding and liquidity mechanisms (Crisis Transmission Mechanisms, Khandani and Lo 2007) For complex and alternative strategies, important risks are about magnified basis risks or tail risks.

Key Points
The Global Financial Environment presents new challenges for investors. The AMH explains that we need to think about the current market environment, the key players in this market, and how they may react to stress. Investors need to focus on adaptive strategies as opposed to past performance. Each market crisis is unique but there are some key characteristics which remain important these include credit, liquidity, and volatility.

Related Literature
Crisis Alpha Articles by Kathryn Kaminski The Emerging Role of Crisis Alpha Investing, AIMA Journal, Q2 2012. Was Managed Futures Tackled by Turbulence? Is Volatility a Friend or Foe? Allaboutalpha.com, May 2012. Managed Futures and Volatility: Decoupling Convex Relationships with Volatility Cycles, CME Education Group, April 2012. (Forthcoming in Opalesque Futures Intelligence Magazine and Barclay Hedge Insider Report) Offensive or Defensive, IPE Magazine, July 2011. Regulatory Impact on the Performance of Trend Following, Stocks Futures and Options Magazine (SFO), June 2011. In Search of Crisis Alpha: A Short Guide to Investing Managed Futures, CME Education Group, April 2011. Crisis Alpha and Risk in Alternative Investments, CME Education Group, April 2011. (with A. Mende) Diversifying Risk with Crisis Alpha, Futures Magazine, February 2011. Crisis Alpha, Presentation: Alphametrix Summit Miami, January 2011. Other Related Publications Billio, M., Getmansky, M., and L. Pelizzon, 2010, Crises and Hedge Fund Risk, Working paper Isenberg School of Management at University of Massachusetts and the Department of Economics at the University of Venice. Lo, A., 2004.The Adaptive Markets Hypothesis: Market Efficiency from an Evolutionary Perspective, Journal of Portfolio Management30(2004), 1529. Lo, A., 2006, Survival of the Richest, Harvard Business Review, March 2006. Lo, A., 2005, Reconciling Efficient Markets with Behavioral Finance: The Adaptive Markets Hypothesis, Journal of Investment Consulting 7, 2144.

Speaker Biography
Kathryn M. Kaminski, PhD, is the CIO and Founder of Alpha K Capital LLC, a thematic fund focused on offensive strategies for tail risk management. Prior to starting Alpha K Capital, Kathryn worked in investment management as a Senior Investment Analyst at RPM, a fund of hedge funds in Managed Futures. While at RPM, she coined the phrase "crisis alpha" to describe Managed Futures strategies with her work in Futures Magazine and for the CME Education Group as a market commentator. She also has quant experience in both emerging fixed income and credit markets. Kathryns work has been published in across a wide range of publications including IPE Magazine, Futures Magazine, SFO Magazine, etc. Kathryn earned her PhD at the MIT Sloan School of Management where she did research on financial heuristics in collaboration with Professor Andrew W. Lo as part of the MIT Laboratory for Financial Engineering. Her research interests are in the area of portfolio management, asset allocation, financial heuristics, behavioural finance, and alternative investments. She holds and has held academic lecturing positions in the areas of derivatives, hedge funds, and financial management at the Stockholm School of Economics, the Swedish Royal Institute of Technology (KTH), and the MIT Sloan School of Management. * In 2011, Kathryn was selected as a PAAMCO 100 Women in Hedge Funds CAIA Scholar. Contact Information: kkaminski@alphakcapital.com Related Websites www.cmegroup.com/kaminski