22 The Most Important Question Investors Should be Asking with Nigol Koulajian of Quest Partners - 2of2

Niels

For you to explain this…a lot of people will have difficulties in getting their head around these types of concepts, because it’s a little bit more than traditional trend following. You buy when the prices move up, and you sell when the prices move down and so on, and so forth. But what I wanted to ask you, because you mentioned in the beginning of our conversation that your upbringing in Lebanon actually influenced the way you designed your systems. So now I want to try and bridge that gap between these very complex models that you just described, and in your upbringing and in inherently unstable environments how does that work?

Nigol

Thanks for the interesting question. Well, you see, we see the world based on our memory of what it’s supposed to be like. It means most people see the world based on their own filters of reality, not based on how it is. So I have filters, people who grew up in New York, and who have never seen a war have different types of filters. So, my filters, when I started out as a kid, my grandfather, who basically lived in the Ottoman Empire, always warned me to always question the system. Don’t believe that a system that looks strong means that it’s stable. That things can reverse at any point in time. Diversify geographically, and don’t bet everything on the economy. So you should have some money in cash, some money in real estate, some money in economic activities such as the stock market. I remember his warnings and these were not just philosophical warnings, for him, it was very emotional, because he had been through this, and he had to run away from the Ottoman Empire, and therefore went to Lebanon, which is where my parents grew up. Now my parents I saw again, the war in Lebanon, the devaluation of the currency, and people who had made a lot of money lose it very, very quickly because they were convinced of something. So, based on the background of my grandparents and then my parents, I basically would rather assume that the world is not a stable place, rather than assume that it is a stable place. Now if you are too scared, then you become dysfunctional, but if you’re too comfortable, which is in today’s world I would say that people are way too comfortable, then they’re allocating to a different type of strategy.

So here’s how it goes in the hedge fund world. In the hedge fund world, effectively today, people assume that there is no risk. I mean, relative to history, we’re trading at volatility levels which are lower than anything recorded. You look at foreign exchange rates, you look at the stock market. Now this is a part of the culture that the typical investor is in, the Fed always comes in and saves you – in the end we always come back. It’s a very dangerous idea, because in case you are wrong, you lose 90%. The stock market lost 50% in 2007 to 2009, and without the Fed intervening, I would say 70%…it was like a question of days, not very far. For me it’s important that I allow my ideas to be wrong.

So how that goes into CTA territory is that it goes in terms of the market regimes have to change and my strategy has to stay alive, one. Second is if a big move comes, I want to benefit from it. I don’t want to pay the price for it. I want to be a buyer of insurance and I want to get paid for it. By what we have done since we started trading, which means we’ve generated about 9% of annual alpha to the S&P with positive skew. It means we were not buying based on value, the cheaper the market gets the more convinced we are that we are right and we buy more. We bought insurance and we got paid alpha on top. So 90% or more of the hedge fund industry is negatively skewed. It’s becoming more negatively skewed because the idea which is sold by the common mind set today is that things always come back. It’s like it’s unpatriotic to assume that the stock market can go down.

Niels

Yeah, it’s funny that you say that – that people believe that things come back – the only thing that they don’t seem to think is coming back is the CTA returns themselves.

Nigol

(laugh) Well, today, yes there’s been a…I would say that CTAs have gone through 5 years of relative difficulty. The CTAs that have done well typically have done well because they’ve sold into the system. It means they’ve actually gone long in the stock market. But the market is not like a money printing machine. It’s there to reward people who do things that nobody else wants to do. That’s where the risk premium is. I’m not saying CTAs…of course today you have to start differentiating between CTAs, because we know the seven factors. We know that most CTAs are not really CTAs anymore. We cannot talk about CTAs as one broad bucket anymore. I cannot tell you when the situation will reverse, but when it will reverse, CTAs will make back all the time lost. It means when volatility compresses, so you take and equity curve, which is a straight line up and then you flat line it or you take it down to a drawdown. When the correction ends, you will see that you go back typically to the level that you would have been if you had continued in a straight line up. So, compressing volatility and distorting markets is not a problem, but when the markets go back, they always go back to reality. They don’t go back to another dream world. So reality at the end always wins.

Niels

Sure, and that obviously is why, in the long term, these strategies have done better than most hedge fund strategies and certainly better than the traditional asset classes, but people in this case at least, have very short memories, because they tend to only think about the last couple of years, where CTAs have done not so well, and equities have done really well. So it’s fascinating because, I see now the link between the…or at least that’s my interpretation of what you said, your upbringing in an unstable world and now you focusing on volatility which is in a sense an expression of stability, or lack of it.

Nigol

Lack of it, yeah.

Niels

I see that link which is really, really interesting. Now tell me…so we have these models, and clearly the way you’ve designed them is unique in many ways, but in addition to the models themselves, what about something like position sizing? Because in many respects I think that position sizing is an undervalued factor by many people. They think that, oh it’s about where we buy and where we sell, but actually trend following, if we take that as an example, is very much about how you size your position in terms of what returns you get. So how does that work in your models?

Nigol

Yeah, so again, a very good question, and broadly, the way I see it, value strategies, mean reverting strategies typically increase their position size as their losing money. The hedge fund industry overall increases its exposure to the stock market when the stock market goes down. If you look at beta non-linear leads it’s measurable. From the perspective of CTAs, or if you are looking for volatility expansion, it’s exactly the opposite. It means you’re expecting that your position size will increase as you are making money. So the position sizing now, before we talk at it at a micro level, broadly speaking you would expect that a CTA, as trends develop, their positions… their risk will increase, normally speaking.

Now how does that translate into position sizing in the real world? First we discussed the fact that value at risk is the most dangerous measurement of risk you can ever imagine for two reasons: first volatility is going to 0 and correlation is going to 0 and tail risk is increasing in today’s world. Which means you look at a certain position, and you look at a certain hedge fund, it has very little beta to the stock market, it has very low correlation to the market, but as long as the market doesn’t go down more than 10% everything is fine. If the market goes down 10% the hedge fund is down 30%. That’s the quick…so volatility is not something that you can rely on. Correlation is not something you can rely on.

So the way we build the portfolio is we use drawdown expectation across different factors as a measure of portfolio construction. So we’re trying to normalize exposure to different factors. So, suppose you have five factors, we would allocate equally from a drawdown expectation in perspective to each of the five. It’s not done numerically. We can do it numerically, but numerically, from my perspective, the more math you utilize the less you know what you are doing, the less you know the reality of the world out there. The more you know about the reality of the world, the less math you utilize.

Niels

But how do you set the drawdown expectation at a given factor?

Nigol

OK, in our second research piece we explained the relationship between volatility and drawdown based on skew. So for the CTA industry, drawdown, I’m talking peak to trough drawdown let’s say over a twenty year period, is about 1.5 times your volatility. That’s for the CTA industry. For strategies which are more positively skewed, drawdown is about 1 times the volatility, and for hedge funds, which are negatively skewed, drawdowns goes all the way down to about 10 times volatility. The proportion of drawdown to volatility is based on skew. So every time the skew goes from 0 to -1 you have to increase your drawdown expectation by 50% of volatility.

I’m giving you one way of estimating drawdown based on volatility and skew combined. You can also look at it through simulation. We have the benefit of having simulation over our strategies, and that also gives us an estimate. Now I cannot give you a broad…broadly speaking if you look at a simulation that you expect to be stable, for a factor that you expect to be stable that works broadly across all markets, I would say that if you assume that drawdown is going to be 50% more than simulation, I think that is pretty safe. For things that are unstable, if you are looking at things that rely on the stock market, or on the fed, or on bottom picking, etcetera, than drawdowns should be 20 times, or 30 times expectation, because it’s been extremely low (laugh).

Niels

No, that’s true. So when you look at your original program combined and you take in all these factors that you have, and models and relationships, what do you see? Do you see the 1.5 times your annualized volatility is what you would expect to lose at any one time, and is that how it’s been historically, or have you been able to improve it a bit over time?

Nigol

We’re more positively skewed than the CTA industry, therefore I would expect our drawdown to be a smaller multiple than the BTOPs relative to our volatility. We target 20% volatility; our historical peak to trough is 24% that was in 2004. I think we’ve improved since by diversifying the ways that we measure volatility, but we’re human so I would say that…Now must broadly speaking, for example, our return to drawdown is actually higher than Winton’s. Since May of 1999, so we’ve done an OK job, I would say in terms of balancing returns and drawdowns.

Niels

Now in terms of implementing all of these models and trades, how busy or how relaxed, so to speak, is it in terms of the day to day implementation of the trades in the original program?

Nigol

OK, again, it’s a question of balance. So at every place within the firm you can have potential bottlenecks. If the individual in charge of those functions is not busy enough, or if he is too busy. So if your trader goes to sleep because nothing is going on all day, that’s not a good thing. If he’s too active, than again his efficiency is going to go down. So we try to balance things in a way that we keep people just busy enough at 30% of capacity in terms of everyday operation. That keeps them alive, thinking, in touch with the markets, and able to provide us feedback and to improve their process constantly over time. So, from my perspective I’m not involved at all in day to day operations. I would say research, so Paul and Nan are maybe spend 10% of their time being involved in everyday operations – more in terms of designing new reports for clients, etcetera, etcetera. Trading is automated. We can automate it more but we don’t feel it’s necessary. Again, you don’t want too much pressure, and you don’t want too little pressure.

The technology and the know how to automate today is available for a very cheap. It’s available and it’s not value added. It means using algorithms to view up over time, etcetera, does not improve on your slippage in the long term. It does so when the volatility is low and you don’t really have to trade, so there are some pretty tricky things here. When you’re executing and the market is not moving, whether you trade your trend following signal today, tomorrow, in one week, or in one month, it doesn’t really matter (laugh). Basically it says don’t trade. Now when the markets are really moving and you get a trade signal at 10AM, if you execute it at 10:10 you’ve lost like 70% of your profit.

So now, when it comes to creating capacity, there are limits in the real world, especially when markets are moving. There are no limits when markets are in a low volatility environments. Trend following strategies are very stable. The typical long term trend following model are very stable in terms of return generation. So you get a trend following signal you can trade tomorrow when the market opens, or you can trade the day after the market opens, you might lose 5% to 10% of your profit, not more. So it’s important to know the value of automation, not to just jump into it because it’s available and it sounds good. For me the moment, from a mental perspective I’ve lost touch with the process it becomes a risk source. Automation is a risk source. It’s not only something that simplifies everyday life.

Niels

But how would you then…does that mean that today you simply implement, say if you get a signal you let the system implement the full position straight away?

Nigol

No, no. So depending on the type of orders that we have, sometimes…for example for the index we’re trading the market on open and depending on our size, we might actually view up over a half an hour or over two hours, or do everything on market open. So for non-alpha type of models, whenever you can be part of the opening cross, you should do it, because that is the lowest transaction cost points, then view up you start trading, you start actually paying a spread. From a perspective of the faster models that have more alpha, that you utilized stops for trading, there we actually have our own algorithms which are not automated. It means the trader has certain rules that he has to follow in terms of how he executes a trade. Typically 50% of the trade is done immediately in the market, and then depending on the conditions after the stop is triggered, between that first 50% being executed, and the time for the second or order to be potentially done, depending on the sectors and on the conditions, there are different rules that a trader follows. But generally speaking…

Niels

Can this be automated Nigol, do you think, because that’s obviously, you know, if you are going to double or triple your original program, you know that obviously requires more man power. The process does not need to be automated. Today for example we’re only manned during US hours, overnight we give our stops to banks for example. But I would say that we would have to have somebody in house 24 hours a day, but the automation does not need to be more than it is. Size is not an issue from where we are. We have over a billion in capacity in the original program and I would say between where we are and trading, being a billion dollars, we would need night traders, not a different process.

Niels

Just out of curiosity, when we talk about risk and we talk about trades and so on and so forth, just maybe for people to better appreciate, and obviously it’s not a specific number necessarily, but what would you say the risk is on any given trade, and I don’t even know because I did not ask you, but I don’t even know whether you use a fixed stop loss for everything that you do, or whether you have to have other conditions met before you have to get out of a trade?

Nigol

No we always have a fixed stop loss. Now again, because our strategies are all positively skewed, the stop loss is very close. For a mean reversal strategy, I mentioned two daily ranges away. For what we do which is more positively skewed it’s much smaller than that. So we always have a stop loss no matter what – non conditional.

Niels

I want to move a little bit from risk management towards the subject of drawdowns. I know that we’ve talked about it a lot already and I want to try and do it in a way where I get to ask you and hear your opinion about some of the questions that I normally do. Clearly the environment since 2009, as we have touched upon has been different. What we’ve seen is that some, probably more classical trend followers, that I don’t think is doing what you mentioned with the seven factors, have seen their drawdowns expand, probably because of the collapse in volatility, to a large degree. But you’ve actually done quite well, if I might say, in this period. How do you view this environment, and, if I can ask, were you expecting actually to do so much better than maybe traditional CTAs in a period like this. From the drawdown you talked about earlier, to put that into perspective, what did you learn from it?

Nigol

Again, we’re not targeting to be a trend follower or to be a Beta. Over our history we’ve made about 7% of annual alpha to the BTOP, and we continue to do so even in this environment. So this environment has changed the returns of our Beta to the CTA industry, but it hasn’t changed our alpha really. So, would I expect to do better? Generally everybody expects to do better, so I’d say I’m one of them (laugh). Now this environment has gone on I would say definitely longer than I expected in terms of the volatility compression. But considering the economic environment and the political environment, I would say there’s less and less room for markets to be normal. It means if we allowed interest rates to go where they want to go normally, the economy would collapse. If the Fed overnight stopped their bond purchases, you would have serious issues everywhere – whether it’s the real estate market or the rest of the economy.

So today we are in a place where markets need to be controlled more than ever. In the context of that, the fact that the volatility has compressed to the way it has compressed is understandable. Therefore the returns that the typical CTAs are experiencing are also understandable. Now not only are central banks providing free puts, you have the hedge fund industry, which is selling tail risk. That tail risk is not seen by the end investor because he gives the money to the hedge fund, the hedge fund goes and shorts puts, or puts on a credit position, he only sees very low volatility and stable returns. He’s not scared. So when you give your money to an institution to manage, the institution can take more tail risk which the investor doesn’t see. The transparency is not there anymore. So you have the hedge fund industry selling tails, and what the internet bubble used to be in 1999, 2000, today selling tail risk is that for the market. It is the source of the returns. So you look at retail websites. They tell you that you can short the VIX by buying and ETF, ETFs are provided that actually short calls on the S&P etcetera, the alpha…people are looking for alpha, they don’t really care the price and the risk that they are taking for that alpha. In that context, there is again a self-reinforcing confidence dream going on, which is the volatility is compressing and the CTAs that are actually betting on a normal market, which is a much more reasonable position, are paying the price. It does not mean that reality has been erased. Reality is lurking and it will come back. There’s no way around it. There’s no central bank that can change this.

Niels

Now, you mentioned you had a drawdown of 24%, just remind me when that was actually?

Nigol

That was in 2004, and the majority of the drawdown came from foreign exchange and effectively at the time, Bank of Japan was kind of supporting the dollar/yen, and there were many consecutive losses, and the way we filtered for volatility did not take into account for central bank interventions. Where today it does so much more than before.

Niels

I actually wanted to go in a different direction also with that, and that is, and luckily for you it’s been a long time since you had this drawdown, but maybe I can benefit from your memory, and that is can you describe what it feels like being in a drawdown. Can you describe that? Because I don’t think many people know what it does to a manager when they get into a drawdown, and it can either be a deep drawdown or it could be a long drawdown, but why can it be difficult to deal with these things from an emotional point of view?

Nigol

You see if you haven’t done your work, then a drawdown is extremely unsettling. If you don’t know your models, if you’re shorting volatility, then having a drawdown is a very scary thing because you don’t know when it will stop. So the more prepared that you are, the more you can handle the drawdown. Now the drawdown is not a mathematical random walk, it’s something very specific that has a very tight and very parallel reality in the world, in the psyche of the manager. It means when we go into drawdowns, it’s just when we think we’re going to make money (laugh). Then when we’re in the middle of the drawdown, we go, oh my God, it was so obvious, we were so confident and we were making money so consistently that we lost track of the potential risks. That’s like somewhere in the middle of the drawdown. Now at the bottom of the drawdown you’re like, oh my God, this is where I would say you have the urge to override your model. You have the urge to change the models to do new research which filters out the specific market conditions that created the drawdown. It’s the same thing which is in, but in the language of the CTAs, oh yeah; I redesigned my models, that’s what you hear. It’s very important to know the difference when you have to react and when you don’t have to react. For that, personally I’ve, for close to 20 years, have a meditation practice and a yoga practice that keeps me detached enough where the risk that you are supposed to take you cannot be scared of. But the risk you can avoid you have to avoid. To see the difference you need to be very clear. If you are scared of your clients leaving, or if the psychology of your clients influences you and you are trying to protect the business, you are going to, guaranteed get out at the bottom of the drawdown.

Niels

And that’s actually where I wanted to go because what you are saying is so important and I think it goes to many managers, that obviously a manager can look inside, and obviously I assume here that it’s a manager that has done their homework, not just someone who has put it together in a quick spreadsheet and so  on and so forth, but the confidence that a manager has from knowing the models and having done the research when you go into a drawdown, whether it’s deep or whether it’s long, you have the confidence that you are going to get out of it and this is not unusual, but what has been really difficult in many instances is to transfer that confidence to the investors. Because we all know investors usually bail out right at the wrong time. So have you found a magic formula to give some of that confidence onto your investors, and if so what’s the best way, in your opinion, to do that, because that’s the critical part?

Nigol

You see Niels, the way I see it is the mind, if you try to intellectually control a drawdown you are not finished from the drawdown yet. At the end of the drawdown your confidence should be shaken, if you are still confident it means you are delusional. You have to be scared. When you are scared, after you have done all of your work, is when the drawdown can end, and this is what I am saying, I know it sounds bazaar but really there’s a major parallel – almost like if somebody can sit and watch my emotions they can tell when the drawdown is going to end. So now what can we pass to the client depends on the maturity of your client. We were lucky that from 2003 to 2010 our single client was actually a CTA. Now we lost confidence before they lost confidence. So we actually told them, you know we don’t know for how long this is going to go on, and it was our first drawdown so we had less experience with this type of thing. We actually told them, we think you should reduce your allocation by 50%. We lost confidence, not them. Now, since then, we’ve gone through many drawdowns, we’ve gone through 20% drawdown 15% drawdown, a few times, so there’s been a few where we have done more work on the systems and we’ve most importantly we’ve done more work on ourselves. So we’re clearer in differentiating our feelings in terms of projections of your fears versus what the reality is doing out there.

Niels

What would shake you today then, Nigol? All the things that you have gone through, what would keep you awake at night? What risks to you see when you look at your design, when you look at your portfolio that could get you back to that situation where you might recommend to a client to redeem 50%?

Nigol

Well, based on where the volatility is today, see if you analyze our drawdowns, our drawdowns have come in periods where the volatility has contracted dramatically. And when I say dramatically, I’m talking about 75% reduction in the level of implied volatility in the market, for example. So you look at the VIX, in 2009 it was at a peak at around 90%. When it went down 75% is 2009 the typical drawdown for CTAs. In 2004 the volatility on the currencies. We recently went through a10% drawdown. We’re 1/2 way back up or more. The volatility on the currencies went from 18% all the way down to 4% and 5%. So when you see these types of volatilities, we’re going to expect a drawdown. If we don’t have a drawdown, it means we’re not actually trading our strategy correctly.

Now, when will I be shaken? I believe 100% in human beings, the crowd psychology, and the fact that they are not able to control their emotions in the market. And I believe that that will continue to give us opportunities. What I worry about is how desperate central banks can be, and how far they will go in terms of controlling markets. Now we’ve done certain things to counter that, to be able to filter some of that out, but of course nothing is certain, so you know the type of confidence that you are looking for, I hope I never have. Because it means I’m missing something. But what I can tell you is the more honest you are with yourself, and the more honest you are with your investors, the less pressure you have to deal with and the more you can focus on the reality versus the illusion. So, for me, do we provide an extreme level of transparency with our clients and that gives me the ability to focus on what I need to focus on, not to worry about if I said something incorrect and now it’s going to come out, or I’m worried about that, or I’m worried about what people are going to think about what I am doing. If I know I am doing the right thing, that’s going to give me the type of confidence that I need, not what clients are thinking. That wisdom…I know the products hopefully better than our clients except in that case. So confidence, there is self-hypnosis, it can work, it’s also dangerous. It’s very good when you are selling a product, it’s very harmful as a manager. As a manager I was taught to always be paranoid. You see what I am saying?

Niels

Absolutely, absolutely. Now in terms of research, a lot of investors they want managers to do research and to innovate, they don’t want the managers to change. How have you come across that situation, and how do you balance that?

Nigol

Well, you have to have wise investors. In our case our investors are mainly very large pensions, and with very few fund the funds as investors. Not to say anything negative about fund the funds, but really that’s the way it is. Now research is a must. Research driven by greed leads to seeing things where there is nothing to see. So if the investor, if you’re not clean yourself, as the manager, then you’re desperately looking for something that’s going to work. You are going to cheat yourself, and your investors. That’s very, very important. So if your investor is pushing for research, he wants to see that you’re alive, that you are interested in your business and you are doing your work – you are keeping up with the markets. It’s very different than, I’m scared of my investors because I need to do this for them. It’s a different mentality.

Now the market provides many opportunities for people who want to deceive themselves, to deceive themselves, especially in today’s world. So I would say that research is very important, not because the clients…because I have, for every idea that we research we have another three ideas that come up. Our minds are constantly coming out and this is how we spend our mental energy is trying to find better ways, or trying to understand the patterns of volatility in the market, or the pattern of behavior, or the crowd better all the time. This is what we do, this is what we breathe. This is, I believe, a good motivation if it’s driven by the client’s it can be misinterpreted.

Our clients, sometimes push the research in certain areas of interest to them. We’ve learned a lot from doing that. It’s been very, very useful to us because they have a different perspective that we sometimes have lost. We’re inside the CTA, they are outside the CTA and their holding an equity portfolio and we’re not, so clients have guided our research very, very often. The fact that we’ve developed the replicator. The replicator was developed at the request of Equinox, which is…a client came and said can you do this for us. We thought it would be a terrible idea, but we said hey if they want it let’s do it, and the next thing you know that’s where we raised a lot of money.

The equity hedge product is the same thing. We’re sitting in front of the client and the client is going, well, the market is going to go down, I really don’t know if you are going to make money or not, and eventually we said we’ll just give you the trades which are negatively correlated to the stock markets and then you know we’re providing you and hedge. We’re not going to be long in the stock market when it drops, and we’re not going to correlate. So listening to clients is very important, but not with the idea to…you have to be very, very careful when the idea comes from the client and the potential for self-deception is much higher. That’s what I want to say.

Niels

And speaking about sort of deceiving yourself and deceiving people looking at it – back tests. You know that’s what we rely on when we do research, but there’s never been a bad back test, at least publicly so how do we…in a serious way, how do we get confidence from a back test also knowing that markets are not necessarily going to look exactly the same in the future that they have as they did in the past. How do we do that?

Nigol

There’s no information in the back test that can answer that. The way you can answer that is by knowing the path that led to the back tests. So when I show you results, you have no idea what I did to get that result. Did I run 10,000 different tests, or did I run one test? So the way the research process works is there are mathematicians that…let say, broadly speaking, know less about the market but can run thousands of back tests in a day, they’re the most dangerous. So mathematicians, PhDs. are high optimizing machines. They are very sophisticated optimizing machines. They don’t know the fact that the market regimes and the market character can change, and because they identify with their intelligence and they want to apply it and they want to prove that they are smart, they tend to over optimize. This is what they were taught. You’re a good mathematician if you design a good model which perfectly matches the sample data. In the market you don’t want that. That’s actually a negative.

So going back to your question, how do you know whether a back test is worth it or not, there’s many things, you start with all the basics which are intellectually palpable such as transaction costs and other technical problems that can arise. All the assumptions have to be correct. Then you have to follow the idea of the researcher. Where did the idea come from? Did it come from a previous test, or running 10,000 tests or you put a machine down and it optimized, or it came from a macro concept, something that you have, an image of a market pattern. So for us, when a researcher does a test, that’s the biggest, in a business there’s operational costs, I would say to the clients, the risk is when a research does a test and does not actually communicate that to me and therefore the degree of optimization is increasing without me knowing, and therefore I misinterpret the results of the back test.

So that’s really critical. So it’s the path to the test, it’s not the test itself. There’s nothing on that graph which always goes up, which tells you anything. Now, I’m simplifying, in today’s world, again, I want to say when you go deeper into the back test. You look at specific factors – I’ve been drawing tests for over 23 years. I’ve seen probably thousands and thousands of back tests. I know some of the factors, the potential optimizations, some of the potential deceptions better than somebody who’s coming in today into the market just fresh. So by looking at factors, by looking at relationships to equity markets relationships to fixed income, you have to know the market, you have to know what exactly what fixed income has done. You have to know exactly what bottom picking has done in the stock market. If you know those, you are already going to eliminate 90% of great back tests. So then the rest is…so there’s a lot of information, but it’s more information and memory is important, but being awake is more important.

Niels

Absolutely. Now just maybe as a final question, maybe a little bit about research which is something that I also know that a lot of the people listening are interested in, and that is how do you know that a model has stopped working?

Nigol

(laugh) Again, hopefully you never think you know. Because if you really think you know then you are really in trouble.

Niels

I guess my question really is are there any sort of yellow flags, red flags that you are looking for that might suggest to you that something may not be as you would like it to be, or what it should be?

Nigol

Let’s talk about trend following broadly speaking maybe. Has trend following stopped working and based on what would you say today that it hasn’t stopped working? Right? Something like that, so if you go back and you say, well, first in the market what can I see mathematically if I want to look at it going back to…some people go back 100 years and they say well it’s worked and it hasn’t worked. Maybe transaction liquidity has gone away, and I would say then it definitely stopped working. It means we cannot trade this time frame anymore because liquidity is not there. That’s obvious. Now, let’s say everybody is doing trend following, so you go in a street corner and instead of seeing a stock or brokers firm you see a bunch of trend followers discussing trends on the wall. I would say it’s possible that it’s going to stop working for a while. If central banks become more desperate, I would say it would stop working for a while as well. If human beings become extremely emotionally detached. It means they are able to separate from their feelings, and they don’t act in the way of a crowd, I would say that trend following would stop working. If risk premia are correctly priced, it means everybody has a fully diversified portfolio. They don’t need to buy insurance any more, and therefore markets will be correctly priced. You will not get paid extra for providing any liquidity to a farmer, or to a bank, or to whatever. There are things that will kill certain strategies, but I don’t see any of those happening.

Niels

So it’s more these causes that you would say that you are looking for, not so much necessarily performance of a model, because…and I remember from one of my earlier interviews with Mike Dever from Brandywine who had been around for a very long time, and certainly knows a few things about trading. In his program he described that we can have models that don’t work for 10 years, it doesn’t matter because we base it on return drivers, and return drivers will have their own environment in which they will work. So if we can diversify across different return drivers, we accept that not all of them will work at the same time, is that a little bit the same as you subscribe to?

Nigol

I agree, you have to have a fundamental understanding of why the pattern that you are trading actually works. That will give you much more information than the numerical observations. So if you look at it numerically, which is far away from all of the examples I was giving, it’s basically a biased random walk. What is the probability of its heading certain allowed drawdown, you calculate that probability. You say if it’s less than 1% possible for this drawdown to happen it means the model broke. I think that’s the least useful type of approach. Every model that you have, in the future will have a larger drawdown than the one you expect. So it’s a question of understanding whether the market conditions have changed versus what you expected for this to happen or not. But it’s not the mathematical process, although we’re running a quantitative approach, etcetera, math has to be used as little as possible.

Niels

It’s fascinating. It’s very interesting. Do you think, and this is just something that I thought about now, given everything that you know, everything you’ve learned, do you think your worst drawdown is behind you or ahead of you?

Nigol

You know it’s very difficult to differentiate the intellect from hope (laugh), when you ask a question like that. So immediately my mind started calculating, is he going to potentially invest (laugh)? So realistically, the biggest drawdown is always ahead, no matter how good you get, really. So I would say it’s better to assume that.

Niels

But then again, also probably the best period is ahead of you because that logic tends to should be applied both ways. Anyway that was just something that I…its interesting and you clearly have thought a lot about these things. I want to shift gears on you a little bit because I have a couple of more key areas that I just want to cover, and this just a little bit on the business side. I want to get to understand your views on that as well, and that is we know it’s been difficult for, in terms of markets, and maybe again as I said, and I’m happy to point out that you’ve done well through this period. But it’s been challenging for the strategies in general and obviously for investors perception of the value of a lot of these momentum base strategies. But it’s also been difficult in some ways in terms of client retention for many firms. What has your experience been? I know you’ve mentioned one example where a large investor had to redeem and you’ve replaced that with other things, but what’s the biggest challenge when it comes to these things and running a business, if we now put the hat on you as the entrepreneur and business man, and not the researcher and the scientist?

Nigol

So again, I would say the key thing is to…first in the past the profitability of a CTA business was much higher than what it is today. It means you put less resources to work, you charge higher fees, and there were less CTAs out there, so the competition was, the market was much more inefficient let’s say. That’s key, the market is very, very different, and it’s accelerating since the replication wave has come in, saying 90% of the returns of the industry are replicatable, and other…if you are looking to specific factors, I would say over 90% are replicatable. So that’s one aspect to be clear on. It means you have to accept as a business man that you are going to have to put on much more costs into the business, and your profit margins are going to be those of a regular business. It’s not going to be 80% distribution to shareholders anymore. The hedge fund industry is used to that. So that’s one key aspect.

The other aspect…so from a business perspective, another aspect is, if a manager is not in touch with the reality of the markets, than he might mis-position his products and his services. So he might be out of the market. There’s a bid to ask somewhere and if you’re not in that bid ask, you’re not going to trade. So with a CTA business it’s exactly the same thing. You have to know what investors are looking for, what they’re willing to pay for it and whether what you are proposing, what you’re offering, no matter where you come from, whether it’s near where the trades are actually happening.

Niels

And I guess that is why you today offer, as I started out by saying when we started our conversation, you seem to be providing solutions that investors are looking for rather than just focusing on one product.

Nigol

Absolutely. Of course I’d rather just do what I think is right, but it’s not long term it doesn’t serve anyone. So the approach of having a two way street with the investors, building products for investors and also telling investors sometimes how they’re misinterpreting market characteristics is something which is most constructive in the long term. So the key, communication is always very important, which means that you have to be open with yourself and then you have to be open with investors, and from there, there is the potential to understand each other better, and to therefore serve each other better. Now we don’t have to be a rocket scientist, you have to have common sense and clarity. From there products can be developed and people have needs and hopefully you can serve them.

Niels

Have European managers been better at doing this in the last 10 years, when you look at the fact that they have become the power houses of the industry, relative to where the industry started, namely in the US? Is that really the reason why we’ve seen this shift do you think? Or is that based on other factors?

Nigol

So it’s a nationalistic pride (laugh)? OK, the US…I have an investor that always says geography is destiny. If you live in New York, you’re not going to first invest in a CTA, you’re going to invest in the New York Stock Exchange. If you live in Chicago, you are going to invest in CTAs before you invest in the stock exchange. So now, let’s say you live in Europe, your idea of the world is going to be more biased towards the reality that you are living in versus the one that people in the US are seeing. In the US the psychology is very broadly pro America, pro business, pro stock market, again it was considered unpatriotic to sell stocks during the crisis. You should buy it, or whatever. So this influences investors decisions, so I would say that Europeans generally speaking have had a broader more open minded perspective on the world in which they have not been pushed away from CTA type investments as much as US investors have. Now European stock markets are up since the bottom in 2009, are up maybe 40% or 50% of what the US stock markets are up. So European investors are still…so it’s not CTAs in a bank world, it’s all relative to the other investments available. So I would say that Europeans are more scared of corrections, where in the US I would say that investors are very confident that the central bank will make the stock market go up forever. So these types of things are a big influence.

Now technologically, I would say that again Europeans are more advanced mathematically broadly as a population. They understand, and they’re more friendly to quantitative strategies. Where in the US people believe in value. They believe in Warren Buffet, the fact that you can buy something which has deep values such as Coca Cola and it will go up forever. And you can take the benefits from that stock – very different psychologies. So Europe, at least at a high school level, is much higher mathematically. So these sort of things influence investor behavior. Now the CTAs themselves, you can look at the Aspect, Winton, MAN trio type of thing, they did certain things starting in 2000, 2002, 2003 such as the inclusion of carry strategies, risk on strategies. Those things at the time were novel and they therefore provided better risk just returns for a while. So you have to give them that. Now they are in a position – they have a very strong position in the industry that they have been able to sustain. Winton continues to grow and continues to create pockets of value that are not potentially from the CTA space, which is fine. You have Transtrend which has provided some very creative approaches to evaluating markets and spreads and you have some very good short term traders as well, so I would say that Europe has definitely succeeded much better than the US in the last 10 years in the CTA space.

Niels

It’s very interesting to see for sure. Now before I jump to the final section, I want to ask you a question that I try to remember at least to ask everyone, and that is the fact that, you clearly, as well as all of my guests, have been in many, many, many due diligence meetings, questionnaires, conference calls, what have you, but I want to ask you what you think investors are not asking you in all of these situations that they really should be asking?

Nigol

Well, you see the most important question in the investment world today is how to price tail risk. It’s not how to price equity risk. The same thing in the CTA world. If I give you a CTA that has 0 skew versus a CTA that has a -1 skew, what should I expect in terms of additional returns per year? That’s the most basic question. So in the same way in the 1960s and 1070s people started to learn about stock market beta and learned how to price stocks more efficiently.

Today investors have to be asking about the pricing of tail risk. When they do that, the hedge fund industry will have…the incentive fees that the hedge fund industries will not exist anymore, and investors will have less surprises. So when they invest in a manager that has 10% volatility, but goes into a 70% drawdown during an equity crisis, they will not be surprised. So this to me is the most important question, whether it is in the CTA space or the hedge fund space, the confusion between alpha and skill is still too prevalent considering the information that is known. This information is the fact that managers are not taking local risk, they’re only taking tail risk, and investors still cannot tell. That to me is the question.

Niels

Now let’s move on to the final section which I define as general and fun, so a little bit of everything.

Nigol

OK (laugh), that’s quite a change in direction!

Niels

(laugh) exactly, now we’ve done all the serious part, now we do a little bit of different things here. In very short…if you can shortly define, what do you think it takes to become a great manager or trader, because a lot of the people listening perhaps people who aspire to become the next Quest and so on and so forth, so what does it take now a days do you think?

Nigol

I would say 20 years ago it didn’t take much, since I made it through (laugh). But today I would say there is a certain clarity of mind to be able to question your own mind is very, very important, not to have unwarranted conviction in the wrong areas. Just to simplify your life. So I would say today, in any business, or in any activity as a matter of fact, having a clear mind which is not driven by your own desires, but is driven by reality is the most important skill in anything.

Niels

Great.  I have a feeling I know what the answer is, but I’m going to ask anyway, and that is a personal habit that you have that you believe has contributed to your success.

Nigol

Yeah, I guess you probably do know the answer. I’ve had a daily meditation practice for 18 years now. I haven’t missed a day. And it’s a very, very, important habit because it’s like people have the habit of taking a shower in the morning, so meditation for me is like a shower for the mind, so the left over memories, reactions, bad effects, good effects of everything that you did yesterday, of what the market did yesterday is in a way erased and you can see the world fresh and clean again. It’s very, very important especially as the industry becomes more competitive, markets become more hidden, like the reality of the market is hidden. The real price is not where the market trades. It’s influenced by central banks and there’s a long of hidden factors. In this type of world if you don’t have clarity of perspective, if you are too influenced by your knowledge, by your memory, you are doomed to fail.

Niels

How did you come to start doing that and how long does it take to do every day?

Nigol

(laugh) the reason I started is because I realized that the way I saw the world was not the way the world was. So my perspective of the world, and actually it was in relation to the death of somebody in my family, I said nobody ever told me what happens after this, so how come all this education and everything I thought I knew was such a shock and as a result I said let me go and actually see what is it really like. Is there a way to get an answer to this, and very quickly I realized that the mind, the intellect…knowledge can actually be a negative, it can be luggage in seeing life as it is. So I started out of necessity, and it had many positive effects.

Now time I would say is not…this meditational technique, transcendental meditation, etcetera, they say 20 minutes a day twice a day. Great, and I agree with that, but I think that even doing 5 minutes a day sincerely has a very, very powerful effect already. So I would say the discipline of doing it every day is more important than the time. So even 5 minutes a day, done correctly would have a very profound impact on all aspects of life. Now from my perspective, I also once or twice a year go and spend 7 to 10 days in silent retreats where all the toys that the mind grabs on and holds on to are taken away from you, and therefore the mind surrenders and other aspects of your personality can actually be seen by you more clearly. So it’s a very cleansing process. Your creativity is magnified and your perspective on the world is very, very different.

Niels

It’s fascinating actually. One of my previous guests also did meditation on a daily basis. And I seem to have read, when you read about people who have become successful in many fields very often you see some level of meditation or allowing themselves to spend time on the internals rather than just the externals, so I’m fascinated by this and I appreciate you sharing that, that’s for sure. What is the most difficult thing about being a CTA do you find?

Nigol

Again, you feel like you’re fishing in a very small pond. In a way we create a self-defined box and now the box is our prison. So CTAs by defining the styles so independently from the rest of the world, so far away from the equity world, in a way have created their own prison. And in today world I feel like, oh, the big guys are playing in a different world, in a different pond and that’s a prison that we created by the way we define ourselves. I would say that’s the most difficult aspect of being a CTA.

Niels

Your obviously, as I mentioned earlier, your also an entrepreneur. Did you always know that you wanted to be an entrepreneur one day? Is that in your Armenian blood that I have to have my own business, or was it more other things that led you to maybe the detours where they didn’t give you the chance to become a CTA, it forced you to take your own initiative?

Nigol

Our personalities are shaped by many generations of experiences – it’s not only our experience, but the generation of our parents, grandparents, etcetera, and it was my Dad and Grandfather always told me that the first chance you get you should start your own business, and I didn’t take them seriously. I was, ‘why would you do that’? You have such nice big companies that you can work in and not worry about anything, but somehow the depth of the feeling when they said that stayed in me, and over time I remembered, and then I took that advice.

Niels

Fantastic. I have two questions left, I think. I want to ask, as business people, as managers, etcetera, etcetera, it’s not a straight path, it’s not just a slope going up, we have hick-ups, we stumble, we fail along the way. What would you say has been your biggest failure in achieving what you’ve achieved?

Nigol

I would say not realizing…I would say the biggest failure is not seeing in 2009, after having two great years, not seeing the reality of the world and the impact that central banks can have. I would say all CTAs today have…first they missed about 200% in return in the equity world, if they haven’t lost money in their own strategies. I would say that’s like really a point where there’s major bifurcation, where sometimes I say, if I had the right clarity, I wouldn’t have been as driven by my own memories…It’s almost like your successes, you remember anything which is dramatic and the fact that you are up 56% while the stock market is down 40% or so. That impacts you so much, that the rest of your life you’re trying to relive that experience over and over and over. And I think that type of negative learning is something that clouded reality for me and for most CTAs I would say, and they refused to be more open minded in terms of where money can be made, and where money can be invested. I would say that’s like a major point. I would have been in a very different place if I was willing to see the world differently at the time. For CTAs those experiences are very marking and it becomes very difficult to do anything different as a result.

Niels

Now you’ve already shared some personal things about some of your routines, but is there a fun fact about yourself that you can share. Something that even people who know you may not know about you? It could be a hidden talent, I don’t know.

Nigol

(laugh) Well, as a kid I actually wanted to be a drummer and to this day, we have gongs around the office, and music and sound are very important aspects of my life, and it’s kind of the way I think, a lot of times I think though sounds rather than through thoughts. It’s rather a bazaar approach to reality, but it’s something that I use to take me away from the mental process. I wouldn’t say it’s like…I wanted to be a rock drummer, that didn’t happen but at least music and sound are still aspects of the way I see reality.

Niels

So when I need a new playlist for my IPhone you’re the one to call I understand.

Nigol

(laugh) I guess so.

Niels

Now Nigol, my last question – I said earlier today that investors may not always ask the right questions and obviously that’s one of my motivations for doing the podcasts, but what have I failed to ask you today? What have we missed, or do you thing we have done justice to you and to your business in the subjects we covered?

Nigol

Unfortunately yes (laugh) you have. Thanks, you’ve been extremely accurate, and your understanding of the CTA space, the hedge fund space, psychology, business in general, I think you’ve covered all areas, at least you’ve dug very deep into all of the different areas that I have anything to say about, so I’m very, very grateful for your attention, your thought and for doing this. This is a great service for people.

Niels

Now before we finish completely, could you share with us where is the best place for people to reach out to you and learn more about yourself and your business?

Nigol

I guess we have a web site questpartnersllc.com. They can send us an email to there and we’ll be in touch and we’ll send them any information that they need.

Niels

Great stuff. And let me also say to the people listening that, for those who are on our mailing list, at least, there is a link in the email that you receive this week, where you can just click to say thanks to Nigol for sharing his story and his expertise, and I would really encourage everyone listening to do that, because that is the best way to show their appreciation, so let me be the first to say to you, thank you so much Nigol. I really appreciate it. It’s been a fascinating conversation and I think your thoughts, your transparency, and your willingness to share this has been phenomenal. I’ve really enjoyed it. I’ve learned a lot, and of course our listeners can find all of the details of this conversation in the show notes and the episodes of TOPTRADERSUNPLUGGED.COM. I also hope that we can connect at a different time. We didn’t get to talk about a lot of the other strategies that you do, but I think there’s plenty of material to do a follow-up at some point so I hope you will be open to that some day as well.

Nigol

Thank you so much for the dialogue and hopefully, yes, we’ll do another one on another topic.

Niels

Great stuff. Thank you so much and take care.

Ending

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