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
- 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
- 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
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
As long as alternative managers remain eager searchers,
and prudent in implementation, investment opportunities
exist and money can be made.