30 Candid CEO: Don't Tweak Your Models! with Aref Karim of Quality Capital Management - 2of2

Niels

Speaking about the portfolio and the universe of markets, and you mentioned commodities. I noticed that you offer, as far as I’m aware, the same strategy but with or without commodities, and I think that’s a big debate actually because it’s clear that people in the last few years who have not had a big allocation to commodities probably did better from a performance point of view in the last couple of years. What do you think or what is right or wrong in terms of should you have the commodities, or should you not have the commodities? How do you view that?

Aref

I think it all depends on your perspective. Our AFP, the Alpha Financials Portfolio, that came about through a specific request from an existing client who was already invested in the JDP, it was actually a fund the funds and they had in turn a pension fund investor who specifically asked if we had a pure financials portfolio, so the request we got from our investor was that, obviously they were quite happy with our strategy and so asked us if we could run some simulations based exactly on the same approach, which we would not change anyhow for another portfolio. We always tend to use the same approach and we just took commodities out. The interesting thing is that people say, so is this a carve out, and I say no it’s not a carve out. In portfolio terms with the labeling, yes it looks like a carve out, but in terms of its behavior, because of the way we trade, the relative value type of an approach essentially results in portfolios that can be quite different sometimes. They both perform.

Clearly those who believe in commodities as an asset class, a non-correlated asset class to the other two major ones – equity and fixed income, for them commodities, to be included in the portfolio so long as they don’t have any policy constraints within them that would be very attractive. In fact, when you look at vol, overall, yes the vol in the portfolio with commodities is a little bit more attractive compared to the vol in the pure financials one. Having said that, in the financials one we have currencies. We look at currencies in a slightly different way in that through currencies in some ways we are engaging into immerging market equities as a proxy if you like. We’re also participating in carry trades to a certain extent with the interest rate differentials, and also into commodities because there are some commodity currencies whether its Scandies, the Aussie and South Africa, and so on, and so forth. In some ways, in the AFP, the currencies play quite a nice complimentary roll because you have equities and fixed income, which are your current traditional assets, and currencies play the buffer role in-between. It softens it sometimes through an interest rate play and other times it will actually be opportunistic in looking for essentially a pickup in risk premier in the emerging markets, or whatever. That’s the reason the volatility in that portfolio is still very, and the return to vol is quite attractive in the AFP. We find that institutions, a number of them, generally prefer…we don’t understand commodities, and you want to own commodities only as a passive asset class almost. You have a portfolio and index link it or whatever, and then for the active part, they prefer things that they understand better which is equities and fixed income, and the relationships are much more observable and predictable in their minds.

Niels

This is a slightly different question. Is it a difficult strategy to explain rather than when you were a medium to long term trend follower?

Aref

(laugh) Yeah. It is, and it isn’t. It’s like with anything. The more you chunk down, in other words, the more you go into layers and deeper, then it becomes complicated. If you keep it at a very high level and say look, people make money by calling directions in the markets, and others do it by just changing the level of conviction. In our case what we have is a mechanism which we believe quite efficiently tries to change those levels, or try to be in step with the markets in terms of changing level of conviction. So that the portfolio is always looked at as a whole. It is a holistic approach, and the system essentially takes care of it, totally unemotional, without any cognitive biases and so on, and so forth. It is not a heuristic approach because there is alpha there in terms of the dynamics of this changing the weights, and that is how we are trying to essentially generate the returns. Ours is not a complicated thing. What makes it a little more difficult to explain is simply a function of the fact of the IEP. Because we don’t want to talk openly about how we’re doing it, so therefore it sounds like it’s more complicated. I do think that the way we are running it is quite different. It is quite unique. In the industry, certainly over the years that I’ve been involved in the other side, and even just following it from when I was on this side, I don’t think I’ve come across any, but maybe there are, but I certainly haven’t come across any myself.

Niels

Why is volatility in your view, why is that a good indicator?  Why is that an important source of information in making investment decisions do you think?

Aref

Again, it’s a part of your own philosophy. It all comes down to your, in some ways, what makes you feel comfortable. Some people tend to play with the prices because it’s much more visible. Volatility is less visible. When you look at the distribution of returns and our strategy is long vol, so we are looking for divergence as opposed to convergence. So our skew that we get in the distribution of returns – the big, fat, lumpy returns that you get so long as you don’t try and truncate those or get in too early and take profits and so on, you let it go. You look at the traditional long term trend follower, all the skews – they would make money maybe 30% of the time, 40% of the time, if you looked at the individual trades in the markets, but you were relying on those fat tails. What they would do, even the minimal basic level of risk management, whether it’s through stops, etc. You are truncating the left side to a certain extent, or trying to manage it. Effectively you are letting the positive skew side work its own way through riding the trade.

In some ways, our strategy still follows that principle because we are long vol, and we don’t want to necessarily curb that upside potential too much. It’s very easy to control drawdowns. You just do it by having a lot of indicators and a lot of things to essentially try and protect you from the left side of the distribution, but what you end up with is you give up quite a lot. Cost of trying to manage short-term noise is, over a period, it’s quite huge and it comes about through an opportunity cost. It’s not visible, but it’s an opportunity cost because what you are giving up is the potential for that big trade, the big trend trade if you like, if you are a trend follower. We’ve tried to find a balance. So when you look at the distribution of returns for long vol, you’ve got a very positive skew, and you look at the guys who are playing convergence – the short vol, and they have a negative skew, in other words they are going to pick up those pennies on a regular basis, but once in a while they’ve got risk of ruin. They’ve got a blowout risk. That’s an iceberg risk that looms underneath.

So philosophically at QCM, I and we as a team, we feel more comfortable with the long vol approach. I feel that we can sleep better knowing that this strategy will correct itself. Is it therefore loss proof? Absolutely not. Where do the losses come from? They come from the lags because it takes sometimes awhile for you to adjust your positions. This system, as dynamic as even ours is, it still takes a little while. The more high frequency you go, the more you want to adjust it. Again you are going to introduce a lot of noise. There is a balance that you have to reach and that balance is entirely up to the manager because you have to determine what you feel comfortable with. If you’re so worried about you not being able to take some volatility, then you have to have this tighter, shorter terms systems that adjust much more quickly, but it’s guaranteed that you are going to give up some of the potential upside.

Niels

Is it fair to say that a low volatility environment actually creates more volatility in your return, and in a sense the low volatility – I call it low volatility environment that we have seen the last few years, but it could be just price range compression, I’m not entirely sure whether volatility necessarily except for maybe equities and some currencies where it’s gone down for sure, but how does that effect you when we have authorities that come in and they really try and manage things and have you in your research seen periods that look somewhat similar to what we’ve been experiencing the last couple of years.

Aref

I think the low vol environment definitely causes errors because it gives you false signals and even in our methodology where you are not taking binary signals, you are essentially adjusting weights, but still you are building up weight and no sooner have you started to build up weight again when the market comes down, so again it takes the weight off. We believe in our current enhanced approach that we adopted in September of last year, and we don’t change our models much believing in the principles of avoiding style drift and so on, and so forth, but even in our approach we’ve had difficulties. The issue is… when you say do you find the volatility increases with low vol environment, it’s not so much the vol increases. Vol actually reduces, however; it’s more astrictive. So in other words you are getting negative, negative, negative months, for an extended period of time and that is what we’ve tried to address over the last research enhancement that we made by essentially trying to avoid so much of this and making the system more efficient in terms of not willing to trade these markets where there is a lot of these whipsaw stuff going on, losing markets and essentially push it out a lot more to things like even fixed income if need be, where you’re not likely to see this kind of vol. Commodities are a classic example of that, between what costs most of the CTAs over the last three years as we all know has been commodities. You’ve had the compression of volatility through the artificial liquidity that was introduced by the Fed and central banks generally, so you have in a compression mode in terms of vol correlations, etc. all but sort of breaking down. You have spurious sort of correlation moves that were effecting giving wrong signals in a way. Short of you saying, well why not stop trading commodities and let’s go and trade other stuff. You can’t do that. You’re job as a diversified portfolio manager is to keep your oars in the water with all of this, and that’s what you get paid for. It has its costs, unfortunately. I look at this in the biggest scheme of things as a cycle. Could we have done better? Sure we could have done better, and that’s what we have done. Sometimes we say our approach is generally not reactive in terms of making any research changes, but some things are a bit of an eye opener. I have to say that what we’ve seen, the kind of environment that we’ve seen over the last few years, since the crisis has been extraordinary. It’s been unusual. This low-interest rate environment, a lot of uncertainty going on and yet at the same time you have one asset class, equities, from 2009 March low has been just going straight-line up. That’s because the function of liquidity. There’s so much liquidity in the system.

Niels

So how do you take an environment like that and find inspiration for new ideas. We know that, as you have said a couple of times, in one sense investors want you as an manager to innovate, but they don’t want you to change because of style drift and so on, and so forth, and that’s obviously a balance in itself, but when you see an environment like this, what do you see that you think that this is something that I could use constructively to improve my model? What are the areas that you are looking for?

Aref

So in our case, because it’s not so much of a multi-model approach. It’s just pretty much one model and the inputs and variables are very few in it and so consequently we look at it like has anything changed so much that therefore the system in itself, the model in itself is not behaving, not doing the right sort of thing. That would be the most worrying thing is that if it was doing the wrong sort of thing, but it wasn’t. It was the lag, and you could see the attrition that was caused, particularly in commodities was the major source of losses. What we did is we said let’s go back. We took a deep dive to the volatility level and actually looked at the vol in commodities and then compared it to the other assets and that is what brought up this point of which we subsequently went on to make that adjustment in the portfolio. That it was really to do with essentially that the sensitivity of our model to the volatility in commodities given that the rest of the assets were not as volatile, because equities as I mentioned were going straight-line up, fixed income was fairly stable, and so it was playing primarily in commodities that were moving around.

Because long vol by nature was picking up, it was attracting more weight. There were a lot of errors that were coming on onto the commodities stuff. So what we said is this is not an adjustment that we’ve made which simply addresses just this environment, it is an adjustment that we made for good because we’ve identified that this is something that we had not looked into because we don’t like to parameterize as I mentioned earlier, so therefore we kept the approach exactly identical across all assets but only to find that there is some kind… it’s a bit like looking at fixed income. You look at the long end of the curve; there’s duration risk. So you can’t trade long end of the curve in the same way that you could in 90 day Eurodollar contract. You have to make some vol adjustment there, or some kind of adjustment risk cap or whatever, which we’ve done as well. This we didn’t do now, we’ve done it before so we’re fine there but the commodity one had not looked at.

Our research is vastly different the way we conduct it. We always get hounded with this question of, so what are you doing in research? The thing is that we’re not a house or shop that is constantly tweaking models and looking to calibrate all the parameters and recalibrate every time things change. People will say, you know markets have changed, so you change the model. Well, markets always change. If you start changing your models, you’re always doing it for the benefit of hindsight, and you’ll be behind the curve. What you’re doing is you’re introducing potential for more errors. I’m not saying that you are, but certainly the potential for more errors. This is something we try and avoid, so one of the ways that we try and avoid that is simply by going higher up and looking at the macro picture and saying OK, what is fundamentally is the model doing the right thing? If it is in terms of the balance of the portfolio, risk, non-risk, and so on, then we are comfortable. The rest of it is just simply a timing issue. It may be a lag, and yes it may cost us, but an investor should feel more comfortable that we are going to get them out of it as soon as things turn.

Our research always focuses on how can we make that adjustment process a little bit more efficient perhaps without introducing something else into it as such. We have, for example, I mentioned the one source of alpha which is the portfolio alignment alpha, and the other is what we call the market reversal alpha. What that is primarily essentially is a hedging tool for us. The dynamics of the portfolio alignment process already takes care of a lot of the negativity in market positions that we have if we’re losing, it will naturally flow and move the risk out, try and move it somewhere else, but what we’ve done is in addition we’ve tried to introduce a cover and this cover is totally, or completely opposite your core position. What that does is essentially to say OK, if I’m long something and the market is coming off, yes, let the core portfolio alignment process continue as normal, but at the same time there will be something that will just come in and move away when it’s not needed but it will come in when it is needed to essentially hedge – to increase the hedge.

This is a dynamic non-linear approach as well that we’ve already introduced and we believe that that has two advantages, one is that it quickens the process just a little bit in terms of taking risk off and taking it to cash, and the second thing is also, when it does push long and it sells, at the core you are already selling into the market, this gives it another push so that effectively you could seamlessly go into the short side a lot easier and a lot quicker than you would under normal circumstances. Essentially it enhances, selectively, the shorts, but at the same time it acts as a hedging tool. There is an alpha there, so that’s what we call the market reversal alpha. So our returns are essentially coming from just those two primarily: the portfolio alignment and the market reversal that make up the returns.

Niels

In terms of overall risk management, is that really how it’s done as you just described having the other model coming in and taking risk off the table or limiting risk or is there any other ways that you somehow allocate your risk within the portfolio?

Aref

Yes, absolutely. Our risk management runs as follows, we have an overall portfolio target vol which has typically been 15% to 20% standard deviation, and then we run risk caps – we have risk caps on every market, so that no one market is allowed to get overly skewed in the portfolio in terms of the attraction of the risk budget, and this risk budget is therefore allowed to float freely between… like in our Global Diversified Program we trade 115 markets. It just gets dispersed across 115 opportunities there, subject to these caps. Then on top of that we have a volatility modulator which essentially looks in a very agnostic way, just at pure market vol and it just says that if vol is suddenly expanded, let’s say has doubled overnight our risk budget, regardless of what our convexity tool says, it will just 1/2 the position. It’s an absolute invaluable risk manager in terms of position sizing. We’ve got that. The third thing is the market reversal aspect of it that I mentioned earlier that has the hedging aspect of it. That automatically will come into play; the fourth thing is indigenous, and that’s the portfolio alignment process. If something is not working then the natural tendency for the portfolio to try and correct by shifting weight off one of the other markets. So that is a very natural process. These are essentially the main risk tools that we use. Obviously we run a fully diversified portfolio. There are a number of managers that if you have a lot of filters, for example, then say you are trading 115 markets, but you may not be in 115 positions. In our case when you say 115, we are actually in 115 positions of varying sizes. We may be in a teeny-weeny position, but we still will have something there because it’s just a continuous process of rebalancing the portfolio on a daily basis.

Niels

I was wondering, and I’m curious about your thoughts on this, and that is we obviously all do research to try and give people expectations of returns and volatility and drawdown for that matter, and for many, many years I think a good rule of thumb has been that people should expect 1 1/2 time the annual volatility as a drawdown and look forward to 6 times the monthly standard deviation, however, people will put it, but what I’ve noticed and what the whole world noticed is that in the last couple of years many trend followers and many strategies have experienced somewhat larger drawdowns, then they had seen before in their 20, 30, even 40 year track records. How do we explain that to a certain degree? How do we get investors comfortable knowing that it’s OK that the profile of drawdowns have changed a bit?

Aref

Drawdown is such a debatable kind of thing. I personally don’t believe in drawdowns at all, never did even at ADIA the reason is very simple it’s a function of outliers. You can never predict drawdowns. It’s like going on a holiday to the beach, expecting perfectly sunny weather at the right time and then suddenly encountering adverse weather or rain for days in a row. These things just happen. You look at just generally returns, compound returns, the way you shuffle them around will not change the compound returns. It’s just the sequencing of it. In one point in time, if you just focus on that, you might end up with three negative months. You just move this around a little bit, positive/negative, positive/negative, and so on, and so forth, you end up with very small drawdown. How can you predict that? It’s almost impossible. However, having said that, it kind of presupposes that you have a strategy that has an ability to correct itself. If you are in a negative skew mode, losing, then the system is not doing anything about it.

You have to assume that the system is trying to do something to correct it. Either you said go to cash, whatever your priority is. That being the case, then drawdown becomes a lot more unpredictable in my mind. It’s just one data point which is why in the older days you were sort of saying your next drawdown is going to be bigger than your last one. People get obsessed with drawdowns and understandably so because they think of the worst, worst possible kind of consequence if they had invested at the time. I think things like just giving the strategy a little bit of room to breathe, looking at rolling returns, for example that’s a 12 month rolling return. That gives you a lot more sensitivity and analysis if you like. That tells you, if you were the worst market timer, this is how I look at rolling returns, if you were the worst market and you bought at the top, but guess what, you hold onto it, not just for 3 months for the drawdown but another 12 months or so on a rolling basis. If the system is able to weather that and come back, then you take a lot more comfort from that. That and taking all the data into account would be things like just taking vol and standard deviation and that kind of stuff, though again that too it depends on the distribution. If you have a skewed long vol distribution, then your vol will always look like it’s higher when, in fact, in reality it’s positive vol. This business of drawdowns is a difficult one. I know that investors look at it, and we too do. I always say that look you’re going to end up with a flawed model, a flawed approach if you’re focusing on drawdowns. That’s the worst thing to do because you are focusing on outliers, and you cannot take the doomsday thing, or whatever the worst kind of possible period and assume that that is going to continue to happen in the future, because you are going to not venture out at all.

Niels

Clearly we know that investors focus a lot on this, and of course in an ideal world they would make use of a drawdown and actually allocate to a strategy and I tend to ask all my guests on the podcast about how to deal with the emotional side of a drawdown? I can almost imagine your answer, but maybe I’ll ask it slightly differently and that is how do we teach investors not to get so emotionally attached to these drawdowns, because there are just so many examples of investors pulling out at the wrong time, and obviously having myself experiences with ADIA, we know that that is part of their success is that is not how they would likely react to a situation like that? So how do we teach the modern day investor to make good use of a drawdown rather than the opposite?

Aref

If the investor has the conviction in a strategy, then drawdowns should be looked at as opportunities. That’s the way I look at it because you’re looking at a curve that is basically going upwards. Consequently any dip in it, should it present itself, and of course they always present themselves, but the magnitude of that is varying depending on how big the drawdown is. But let’s assume there was a significant drawdown. I think that’s a great opportunity to buy. At ADIA, and certainly during my time we would look at it not necessarily in a bad way unless we saw that our worry would have been if, in a drawdown the manager starts to override and start tinkering, then the model is not the same. You are not allowing that model to try and come back from the drawdown because you change some parameters in the process and you may have capped your opportunity to come back and that would be a lot more worrying.

In terms of investors, what we need to do is just basically tell the investors that this is a capital growth strategy. It is not an income generating strategy, so it will have some volatility and nobody quibbles when you look at equity markets. The NIKKEI dropped 70%, 80%, and S&P dropped 38%, 40% whatever the figure was, nobody talks about that. It’s only when it comes to these active strategies, and CTAs say, oh, very volatile and big drawdowns. It’s nonsense because the recovery period for active strategies as CTAs and managed futures is far quicker than you would with some of these drawdowns in the Beta world. The way to look at it is how much wealth do you compound over a period? At QCM, in spite of about three years, we say over the 18, 19 years we’ve compounded over 500% return even after allowing for the three lousy years that we’ve gone through. Now that surely tells you that this strategy is capable of generating the wealth in spite of the pull backs and the setbacks that you from time to time will have. Admittedly over the last three years that’s been the most challenging, but things pass. Memories are short. After a while it becomes a little blip in the cycle of things.

Niels

Now speaking on longevity and track record – in your case almost a 20-year track record. It’s a great advantage to have you on because you have the investor knowledge as well and I just wonder how should investors today evaluate track records given the fact that the approaches, the models, whatever we call it have changed over time, and rightly so because we all evolve, but how do investors make sense of an historic track record keeping in mind, if we take the fullest systematic approach? I think there’s a lot of mileage in looking at, for example, ask a CTA to show the track record or in fact show the backtest of their current iteration of the model. I think that’s an important thing to do knowing full well that there has never been a bad backtest, certainly not in public, but I just wonder if we are going to help investors better understand track records, what should they be looking for, or should they not pay too much attention to that and maybe focus elsewhere?

Aref

I think the first level of comfort you give to the investor is really in terms of opening up a little bit about your strategy, giving them some degree of transparency. Whether you do it through NDAs, etc., which is almost essential, but the biggest comfort from an investor perspective is if he really understands what you are doing. That tells them how the dots connect, basically, and whether it’s making sense to them. Has this approach or strategy got the ability, or got the resilience to fight difficult conditions and how does it get out of those difficult conditions? The second thing is that if you start changing models, any manager that actively changes models to me is a difficult proposition, but I know that I am so wrong because I know that some of the big guys they 1,500 PhDs and they are constantly looking to change stuff and do things, but you know, again this is strictly my own opinion.

I’m very uncomfortable with that because philosophically I think in a slightly different way because I thing that if you are doing this now, then you’ll be doing it again in another two months. What does that strategy mean? What do those models mean? Other than just to buy into, or develop a confidence into your ability to be able to make those calls on the changes that you are going to be making, not just now, but in the future. Is that a sustainable business philosophy? I’m not so sure. What if the founder goes and then somebody else comes and then there are changes going on so that then the whole thing is changed. The model and the whole approach is changed and you don’t have the confidence of saying OK but I knew so and so and I have enough confidence in him because it’s not him, it’s the business that you are placing confidence in. So the changes that take place, I think we as managers… I see that all the time with clients and prospects in terms of investors, institutional investors, that they do get concerned.

At the same time, you do need upgrades to your models. We’re not talking about changes; we’re talking about upgrades. So whether there’s an iPhone version 6 coming out or whether there’s a QCM model 5 version coming out, that’s fine so long as 5 is not radically different. You have not done something that it is no longer an iPhone; it’s something else, or it’s no longer the QCM model it’s something else. Therein lies the dilemma for every manager is that how do you convince investors that look you are on the lookout for ideas, you are trying to be innovate, you are trying to be creative, you’re interest is aligned with theirs that you’ll be looking for better ways to do things, but at the same time not make them nervous, oh, you’ve changed a model 3 months ago, or 2 months ago? Gosh, now we have to wait to see how it behaves for the next two years, or whatever. That is a problem. We made these enhancements last September. They’re not even major enhancements, but they’re quite powerful we believe because we have identified a couple of good things that we could hit on. But at the same time there are people out there on the fence saying OK, we’ll keep tracking you for a bit longer because you changed the model. We say we haven’t changed it we’ve just upgraded it, and it’s just a minor thing.

It is an issue, but with all systematic strategies I think you are going to have this because when you have a discretionary trader you can talk until the cows come home about why you are doing something and not do it still. Here it’s important that level of consistency and discipline that you apply in your running of this systematic process, and that is crucial because otherwise the model is changed, and that means the profile is changed and if you start tinkering with it too much. I think this is a bit of a slow and educational process, and some investors are coming around to it. They’re saying we wanted a nice balance between your quest in terms of research and new ideas, so that we can see that our monies are being put to good use for the betterment of our own investments as well as other investors, but at the same time don’t scare us by changing it too often.

Niels

Do you thing, and again this is something that I just thought of, it occurs to me now, speaking to you about it. Looking back from 20 years ago when you started and obviously with the position that you had in the industry anyways, at least I remember back then that when you met with investors you often would meet with the decision maker. You would meet with the head guy or the head guys, and you would be able to explain your strategy and they would be able to get a feel for you and I think to a large extent that they were buying the people behind the strategy. Now I get the sense today that we now, when a meeting takes place, it often takes place with analysts that are somewhat removed from the final decision, and they have to then go and present to the investment committee what they found and therefore it may be sometimes easier to latch on to the statistical side, to the numbers and say, oh these are great numbers because you can’t really convey the personality and describe your impressions of a person that you meet so easily. Maybe hopefully the podcast, by hearing your voice and your passion can do a better job than that, but I’m just wondering if the investment process from the way investors make decisions now have changed because of that, because most managers cannot get to meet with the decision makers anymore?

Aref

Undoubtedly. This is the biggest challenge that we face because as a business gets older and more mature and the infrastructure builds and you have your marketing or business development group out there trying to get meetings and stuff it’s very difficult. You end up with a lot of analysts and there’s nothing wrong with analysts excepting that a lot of them don’t have the experience and the touch and feel and they got overly preoccupied with the statistics of it which is what you just said is absolutely 100% right. It is a major problem. Communicating a strategy today in this day and age with busy investors who only want to deal with emails or hardly even a phone call, or just meeting some junior analysts it does cause a lot of problems for us too. We’re always trying to see how best to be able to get this message across in a way that is perhaps simple enough but attractive enough for the analyst to grasp so that he can take it to the next level, or alternatively trying to find ways of getting somehow to the higher echelons of the institution. It is a major challenge, undoubtedly it is.

I think that old touch and feel and hearing the real story being told to the right person by the right person from the manager’s side, that is becoming a scarce opportunity these days simply because people are just too busy time wise. The analysts have to protect themselves. They want to make sure that the numbers look right, etc. In some ways it’s unfortunate because you are missing out just by looking at the basics of these things, whether it’s asset size or whether it’s just the pure numbers and statistic, you could be missing out on good strategies that are out there that could add a lot of value. Just running, number crunching, and doing statistical correlation of risk numbers, etc. so much of it is garbage, meaningless stuff in my mind. At the end of the day, a lot of it is just common sense and saying OK does this make sense what they are doing.

Niels

I want to jump to a slightly different topic which is the business side of things and I wanted to ask you… clearly you’ve been asking questions of managers and you’ve been receiving questions from investors and potential investors for a very long time, so I’m sure you have a wealth of examples, but I wanted to ask you what do you think investors are not asking you when they come to visit you? What should they be asking but they’re simply not? I guess it goes to what we talked about before that often the questions end up in one direction. We agree that they’re missing something, but then the question is what should they ask to get that out of a meeting, out of a visit in a sense?

Aref

I think from a strategy perspective I would say the economic alignment of the strategy or the rationale behind it sometimes gets missed out. They just want to jump straight into the models. What does a model do, this and that. As opposed to understanding really at the higher level the philosophy, and in some ways if I’m there at a meeting, in some ways it’s a great advantage for the investor to pick my mind and brain, because at the end of the day it’s our products that we’re trying to offer to the investors, so consequently you’d have thought that you’d want to understand really what’s the thinking behind this rather than what it is. I think that this is probably one of the biggest philosophical aspects that is missing from the investor.

Niels

So it’s the why, it’s why we do what we do not so much how and what?

Aref

Exactly, exactly, or even to say why are you in this business in the first place? To be able to pick up that passion; I don’t need to run this business anymore, but I’m extremely passionate about it and I love what we do. Even questions to do with this research of why employ and why not employ too many people in the research side. To get a good understanding of why it is that we don’t need 50 PhDs here; this is a very scalable infrastructure and with systematic approaches that’s the nice thing that typically it tends to be quiet scalable. It’s not additive that you have 50 people means 50 times the brain power; it doesn’t work like that. There is an element of creativity, experience, knowledge that all come together on which there is really no quantitative measure as such.

This is quite important for investors to grasp that instead of asking questions like oh, the research team, why is it small, or why have you not hired more people or what is your research budget, that kind of thing? It’s almost like, given that you have this team, what do are you all doing? What’s the direction that you are taking? What inspires you in terms of research? I would say more philosophical type of questions as opposed to mundane routine, because any analyst can do those kinds of things in terms of the models and how they work and so on, and so forth. Why do you feel that you can add value to their portfolio? Just asking the same question in a slightly different way I would say.

Niels

Yeah, sometimes that’s all it takes I guess.

Aref

Yeah, that’s how creative thinking comes about. By asking the same question but in a slightly different way. If I say 5 plus 5 equals 10 everybody knows that, but if I say  ? plus ? equals 10, it’s the same answer, but it’s infinite ways of getting to the same answer and that’s what encourages creativity.

Niels

Now Aref, time flies when you’re having fun. We’ve already spent a couple of hours talking about this, and this is great, which I really appreciate. I want to jump to the final section just so we have a chance to cover some of that as well, and we can always revisit other things at a later date. I want to ask you… and some of the things about the why you’ve already talked about, so I’m not going to ask that of you, but I appreciate you mentioning that as a good question because that was my next one, but I want to ask you about, based on all of your experience what does it take to become a great fund manager do you think? What are the personal traits that a manager should ideally have in his or her arsenal to become one of the successful ones?

Aref

For me you start off by thinking of this as a business if you are going to become a fund manager, think of it as a business, even if you are investing for yourself, it doesn’t matter. That immediately makes you focus on the activity of investing and it also, by looking at it from a business perspective, you detach yourself a little bit from the emotional aspect of it in a sense is the business going to have an element of continuity and longevity, which sort of leads on to thinking long term. So don’t think of the business for now, think of it for life. Therefore, you will have to be prepared to go through ups and downs and use these as learning experiences because these are valuable experiences. I would say get rid of the cognitive biases. Avoid emotional biases. Learn the concepts of, if you’ve made a mistake consider that as a sun cost and accept it and learn to accept losses, there will be losses in the final tally it’s like losing the battles, but be prepared to win the war. Have the stamina to pick up and move on. This is quite important. Develop your style and philosophy and get comfortable with it and let it evolve naturally. Don’t force the changes under pressure from either… you feel that investors are putting pressure on you to change things or you yourself feel like you’re falling behind if you’re not going to change. That is absolutely the wrong thing. Let it evolved in a very natural way because otherwise you’re going to end up with doing things that you will perhaps regret. Not to get wrapped up about finding unique market characteristics, trying to take an agnostic approach, trying to treat them all as similarly as possible. They’re not totally all similarly treatable, but as similarly as possible and this avoids the tendency to start fitting your approach which is quite important – the robustness element of it. So that all avoids the style drift.

Discipline is absolutely crucial. Do not override your rules I would say. This is very important. Do that as a part of a process as opposed to reactively. Don’t over react to things. Do not complicate things adding lots and lots of inputs and models, and don’t keep changing models. Basically try and keep it solid, simple, crisp, and clear, where you know how the parts are moving together. I would say, probably in the final analysis, have some economic rational which is the most important thing behind the story, behind the strategy and don’t necessarily follow linear thinking, but have some lateral thinking going on at the same time.

Niels

I wanted to ask whether you and, part of my final section is really trying for people to get to know you even better and so I hope you have something you can think of, but is there some kind of a personal habit that you do that you think has been instrumental in your success?

Aref

Yes, absolutely. That’s the art world I have to say. I am very much into the art world, whether it’s visiting galleries, paintings, I love music, I love opera and I have just come back from Verona. I was watching Verdi’s Aida, which was amazing. At the same time, a month or two ago, I was in New Orleans for the Jazz fest that I saw. At one time, I was very much into rock music, as one goes through those periods – Robert Palmer of Led Zeppelin was performing that was fantastic, I went with a bunch of friends. Yeah, I feel, and architecture…I love architecture. I went and visited the Guggenheim Museum for Frank Gehry’s work, and we go to the Tate Modern here and Herzog architecture, there’s so many; photography I mentioned already I love, poetry I love. All these to me really open up that other side of the brain. That’s the side I really enjoy because then…it’s like creativity when you look at an artist. Why is he able to create? Because he thinks freely, he has no bounds. He’s got a piece of paper or a canvas, and he starts in an unbounded way, letting it flow. I think the art world is crucial. The moment you start going straight into the micro stuff and not being able to see the bigger philosophy of how these things come together, at the end of the day it’s all behavior isn’t it. That’s what drives markets; it’s all greed and avarice and happiness and it’s all emotions, right? The art world is directly linked to emotions. How you move the brain, how you move the mind is directly linked, in my mind, whether it’s music or whether it’s something aesthetically beautiful. Even trends you look at it whether it’s restaurants or whether it’s fashion, you see a suit is a suit, but at the end of the day different designers…you go to Giorgio Armani he’s got the unstructured look, or at least he did; you go to Tom Ford you’ve got the really sculpted fitted kind of…and these things come and go – they change – but at the time it moves emotions and so you end up going and buying because this is it. Also, the fact that there is a herding effect. Something catches on and you want to share it with others and be a part of it. I think all of these are related to the other side of the brain which is less of the analytical but where the mind freely floats and flows, and I love that world, I really love the world.

Niels

I’ve got just two more questions that I think that I wanted to ask you, and one is somewhat related to what we just talked about, but it’s slightly different, and that is if there’s a fun fact about yourself that you can share. Something that maybe even people who know you reasonably well may not know about you?

Aref

Through my art world I kind of engage in a lot of fun because I tend to travel even for weekends and stuff, oftentimes with friends. I enjoy…my hobbies and interests are quite varied, whether it’s the beach or going skiing or whatever.

Niels

If I can interrupt… Do you perform any art yourself or are you just someone who enjoys consuming art?

Aref

Sadly I don’t perform as such, and it’s more consuming I would say. I enjoy the pleasures of the skill set that others have brought into focus for me, and I greatly appreciate that. I would love to be able to develop some of these skill sets. I tried to induce that into my kids by getting them into piano and stuff, and this is something Dad didn’t get a chance to do, but I think you should. A couple of them went to grade 7 or 8 in piano, one of them has kept the interest still up and alive, and the other one is being lazy an doesn’t do so much of it. No, I really enjoy…I did write a little bit of poetry just for my own kind of pleasure really. I guess that’s the only part of doing it myself I would say. Who knows, one of these days I might get around to writing a few more just for my own satisfaction. It’s a great world when you know how to scan it for the things that really tick with you, what gels with you. In some ways, we’re very privileged to be in a world of hedge funds which is highly stimulating for me. I love that part and at the same time be able to enjoy the rest.

Niels

Yeah, the best of both worlds.  Now my last question, I asked you earlier about investors not necessarily asking the right questions or failing to get to the important point, so I need to be critical of myself of course, so I need to ask you what didn’t I ask you today that I should have? What have I missed in our conversation, and I want to make sure that I’ve done justice to you and to your firm?

Aref

I guess the one question that probably begs to be asked in some minds, though not a pleasant one is the difficulties in the business that we’ve been through over the last recent period. We’ve had some redemptions, etc., so assets have come down quite significantly from where we were, but that is real. This is how things are, but as I mentioned, long term is something that is very crucial to me – I’m passionate about it, so we’re looking to, and we know that we will, build back the business. We have great product; we have great infrastructure, and we have some good people even though we’ve downsized a little bit, but still we have 15 or so people in the team, and that’s a good number and I enjoy working with the people. The performance side will come out of it. I’m sure the whole industry will come out of it, and things seem to be settling down, we’ll see. Other than that I think you’ve covered quite a lot really. Maybe at some future point, if there’s any specific topic that you want to discuss we can go back to that.

Niels

I actually do appreciate you bringing up that final point because I didn’t want to go there necessarily other than in very general terms. I think it is as you say I think it’s a real thing and I think it makes you really real to bring it up at the end and acknowledging it and also giving the confidence that this is, as you say, things go in cycles, businesses go in cycles, markets go in cycle and if you have a strong belief and you have a robust approach things tend to work out in the end. So I really do appreciate that.

Aref

Yeah, absolutely. The fact remains that I’ve got a lot of my personal monies committed to this, and I’m really excited about what we’re doing particularly post these enhancements that we made. I’m sure that down the road those who are tracking us will see hopefully through the numbers, hopefully better still through face to face meetings and get a feel for what QCM is all about, but the commitment remains very solid and those difficulties we put behind and we just move on.

Niels

We look at this as we’re hedge fund managers, and that’s the business we’re in, but in fact, we are entrepreneurs and the life of an entrepreneur is the ups and the down. This is just part of how it is to run a business and we know that if you can go from 0 to a billion dollars, as you have done, you can do it more than once, that’s for sure. But anyways, I do appreciate this and I wanted to ask you just at the very end where’s the best place for the listeners to reach out to you and learn more about QCM?

Aref

Well we’re available obviously… the best thing is to just email us at our business development Faaria also happens to be my daughter and is working with us. She’s head of the business development side, so her email address is faaria.kenny@qualitycapital.com this is all in the website actually so. A lot of information at a very basic level will be there, but there’s no substitute for a chat or even a face to face meeting, time permitting from an investors side, because as you’ve seen today, in this session you covered a lot of ground. You asked some very good questions and deep searching questions really. Hopefully, I’ve been able to articulate in such a way that it gives investors some degree of confidence in what QCM is all about.

Niels

Also, I can mention to our listeners that, of course, all of the details including the contact details will, of course, be in the show notes of this episode on the TOPTRADERSUNPLUGGED.COM website.

Let me finish off, Aref, by just saying thank you ever so much. I really enjoyed it. I learned a lot. I thought it was fascinating to learn more about you both as a manager and as an investor and of course the link to ADIA we can all learn from. As I mentioned in the beginning, I really appreciate your being very open about it and sharing this with us and I hope we can connect at a later date and see how all of the great work that you do, how that’s progressing.

Aref

Wonderful, thank you very much, Niels. That was a great pleasure to spend the last couple of hours on this call.

Niels

Thank you so much Aref. Speak to you soon.

Ending

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