Fund Investing

Originally published in the October/November 2011 issue

In more than two decades of investing in financial markets I have always held fast to one belief: creating superior performance for investors is ultimately a philosophical issue. It is about having a distinct conceptual approach and then matching it to the dynamism of financial markets. That is how you manage risk and generate alpha.

There are some big questions which all hedge fund managers face in the post-Lehman environment. Is my strategy the right one? Am I implementing it effectively? Am I constantly adapting and improving in the face of market developments? And do I have the best, the most effective and the most flexible technology platform? In the world of 2011 technology enables the intelligent manager to adapt faster and to implement better, all the time. Technology is what separates the lead steer from the rest of the herd.

At IKOS, we measure what we call our ‘strategic distinctiveness’, or the percentage variation of our returns which cannot be explained by the variation of our peers’ returns. Having identified and systematized our ‘strategic distinctiveness’, we go about implementing it using a scientific process, which has to be capable of change.

Testing the hypothesis
To set up a systematic process, to analyze and test its hypothesis before applying it, takes time and investment in technology. That is why our ‘strategic distinctiveness’ is persistent over time, and why it is more successful than shorter-term approaches.

Quantitative trading in a post-Lehman world has been marked by frequent periods of excessive volatility, as evidenced by dislocation in the relationships between markets, by the breakdown of the traditional carry trades, by big trends in safe haven assets and by a proliferation of unique events. This has been interleaved with periods of relative quiet, where correlations and relative value oscillate around equilibrium and less volatile trends. From a purely quantitative trading point of view, the key to success is the early detection of the onset of volatility, which in turn favours models which profit from dislocations in a timely fashion. During quiet periods, the key is to allocate correctly within the available portfolio of models that exploit relationships between assets and captures short and medium trends. That is easier said than done. But now we have a lot more information than before because we have experienced a series of events marked by high volatility. So it is possible to develop further our ability to learn how to forecast potential dislocations, and to profit from those dislocations.

Managing performance fluctuations
At any time in history it has been difficult to deliver growth with improvement. But innovation, particularly in science and communication, enables us to overcome these difficulties. Risk management is the process by which we manage dynamic systems so they operate within acceptable limits of performance fluctuations.

I believe that no short-term strategy is ever sustainable. This approach to trading often leads to correlation, through trade concentration and crowding, and contagion when risk cannot be controlled due to market shifts, and the trade breaks down. Similarly, model concentration occurs when traders use the same “algorithms” developed by vendors or banks, either for analysis or execution. At IKOS we do the opposite, by developing our own proprietary systems and navigating away from crowded trades.

Putting a high value on liquidity
Investors often undervalue liquidity and do not appreciate that illiquid markets flatter mediocre strategies. But at IKOS we place an unusually high value on liquidity. Good systematic strategies are more likely to be developed around liquid and transparent markets and instruments where there is better pricing data and asset allocation can be more nimble.

The evolved manager of today, who is the electronic manager, can navigate away from crowded markets through trading, and resource, philosophy and location independence. We must never underestimate the importance of a powerful and properly overseen market infrastructure.

In a global economy, trade relationships, idea sharing and capital flow generate connectivity of resource management and growth cycles. But for investment managers globalisation brings with it the risk that even the most differentiated and diversified processes will experience losses when asset classes and regions move in lockstep, thereby taking the ‘hedge’ out of hedge fund. A strong technical infrastructure, an evolving process, and the willingness to learn from each market cycle provide the path to asset protection and sustainability.

Issues for investors
IKOS has delivered significant performance throughout these last few years of global uncertainty, precisely because it has maintained a very clear focus on both applying and developing its process including placing a much greater emphasis on risk management.

Looking to the future, there are three major, long-term issues for investors and trustees to worry about.

First and foremost, the EU does not have adequate cybercrime laws. That means proprietary technology and innovation – the very platform on which the best hedge funds are built – do not have sufficient protection. If Europe is to be a driver of world growth, technology and good risk management in financial markets, then Brussels has to develop and apply an EU-wide cybercrime law, similar to the US. And that needs to happen fast.

Second, we already have EU-wide investment structures in the form of UCITS funds. They are sold in dollars and euros, across many jurisdictions. The euro as a currency has to be stabilized and underpinned by proper institutional reforms. Europe cannot go back to the fractured markets and inefficiencies that existed prior to the implementation of the euro.

Third, the rise of volatility across all markets has been notable since 2008. For investors, excessive volatility destroys the ability to ascertain value. Volatility distorts returns and forces quick changes to leverage. Banks can’t sell illiquid assets fast enough in times of high volatility, nor buy them fast enough in times of low volatility. Less leverage leads to more short-term focus from investors, as cash truly becomes king. The rise of real assets, such as gold, as alternatives to cash reflects doubt about fiat currencies and government policies everywhere.

What now is required is greater global coordination of monetary, fiscal and regulatory policy. The uneven playing fields across Europe, the US and Asia are more than just an arbitrage, they are themselves sources of volatility and have the potential to trip up global trade, finance and trust in markets. Nations trying to go it alone by, for example, breaking up the euro or devaluing the dollar, or pegging their own currency, isn’t a solution.

Things could get worse if governments and leaders don’t start working now to fix the imbalances. Global institutions, like the International Monetary Fund and the Federal Reserve, must continue to take on board the views of market participants. If we don’t act soon and act together, then the forces that have led to the great uncertainty which characterizes our age could become even more disruptive and unpredictable. Confidence is the most precious commodity of all in financial markets and it can only be created by all of us taking the wisest possible decisions.

Elena Ambrosiadou is the founder and chief executive of IKOS Asset Management, a quantitative fund manager.