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The Emerging Role of

Crisis Alpha InvestingKathryn M. Kaminski, PhD

CIO and Founder Alpha K CapitalVisiting Lecturer Stockholm School of Economics

Visiting Lecturer MIT Sloan School of Management

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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

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The Modern Market EcologyPrices reflect as much information as dictated by the

combination of environmental conditions and the number and

nature ofspeciesin the economy, or, ecology. Species are

defined as distinct groups of market participants: ex: pension

funds, retail investors, hedge funds. Andrew W. Lo, 2004

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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.

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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 BusinessReview, March 2006.

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Adaptive HeuristicsHumans 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?

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Equity Market CrisisWhen equities go down:

Most investors have a long equity bias (including hedge fundinvestors) and as such they are effectively driven to action

Most investments have specific drawdown, de-gearing andrisk 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 ofinvestors are forced and/or driven into action.

Source: Kaminski, K. 2011

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Crisis Alpha OpportunitiesWhen 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 createspredictable 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 becompetitive.

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

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Case Study: Managed FuturesManaged Futures invest in futures markets viaprofessional money managers: Commodity TradingAdvisors (CTAs).

Directional: The strategies exploit directionalmoves in futures markets prices upwards ordownwards.

Globally diversified: Trade both long or shortcontracts in FX, interest rates, stock indices,energy, metals and soft commodities in regulatedand interbank markets worldwide.

Regulated: Managers are typically authorizedand regulated by financial supervisoryauthorities, such as the FSA in the UK, theCommodity Futures Trading Commission (CFTC)and the National Futures Association (NFA) in theUS.

Futures Markets

Liquid

Transparent Reduced counter-party

risk

Regulated

No asymmetry betweenlong and short

Cover a diverse range ofasset classes

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In Search of Crisis AlphaManaged Futures

Highly liquid trading

strategies with minimalcredit risk tradingexclusively in futuresmarkets

Systematic, void of longequity bias

Active across a wide rangeof asset classes

Less susceptible to the

illiquidity and credit trapsthat most investorsexperience during equitymarket crisis

Less susceptible tobehavioral biases andemotional based decisionmaking

Poised to profit fromtrends across a wide rangeof asset classes

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Decomposing Crisis Alpha

Source: Kaminski, K. 2011

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Crisis Alpha and Barclay CTA

Source: Kaminski, K. 2011

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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

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The New Normal?The Modern MarketEnvironment

Increasing globalizationof financial markets

Increased level of

integration acrossfinancial markets

Increased push forfurther financial

regulation Accelerating speed of

information transfer

The Result

Increased cointegrationof financial markets

Lack of diversification

Potential for increased

coordination in marketparticipants via complexcounterparty networks

New regulations may

simply lead to furthercoordination of marketparticipants

Source: Kaminski, K., SFO Magazine, July 2011.

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Send in the TailsRecent research in hedge funds during crisis has demonstratedthat many hedge funds are holding common latent idiosyncraticrisks in credit, liquidity, and volatility. (Billio, Getmansky, andPelizzon 2010)

Many risks are not measurable using traditional methods

Complex interconnected networks of counterparties cancreate hidden commonalities in risk factors

Complex funding and liquidity mechanisms (CrisisTransmission Mechanisms, Khandani and Lo 2007)

For complex and alternative strategies, important risks are aboutmagnified basis risks or tail risks.

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Key Points The Global Financial Environment presents new challenges for

investors.

The AMH explains that we need to think about the currentmarket environment, the key players in this market, and howthey may react to stress.

Investors need to focus on adaptive strategies as opposed topast performance.

Each market crisis is unique but there are some keycharacteristics which remain important these include credit,liquidity, and volatility.

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Related LiteratureCrisis 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 ofPortfolio 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.

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Speaker BiographyKathryn M. Kaminski, PhD, is the CIO and Founder of Alpha K Capital LLC, a thematic fundfocused 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" todescribe Managed Futures strategies with her work in Futures Magazine and for the CMEEducation Group as a market commentator. She also has quant experience in both emergingfixed income and credit markets. Kathryns work has been published in across a wide range ofpublications including IPE Magazine, Futures Magazine, SFO Magazine, etc.

Kathryn earned her PhD at the MIT Sloan School of Management where she did research onfinancial heuristics in collaboration with Professor Andrew W. Lo as part of the MIT Laboratoryfor Financial Engineering. Her research interests are in the area of portfolio management,asset allocation, financial heuristics, behavioural finance, and alternative investments. Sheholds and has held academic lecturing positions in the areas of derivatives, hedge funds, andfinancial management at the Stockholm School of Economics, the Swedish Royal Institute ofTechnology (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