102 The State of Institutional Learning of Investing with Nigol Koulajian of Quest Partners - 2of2

Nigol

…against it, which is what all those mean reversion models that you see today are.

Niels

So I think I agree with you, meaning that I’m just making sure that I fully understand. But, it’s true, and I think it’s true as well in the trend following space that those firms who really find something unique to do, they could be called a trend follower if they do something unique. We see that there are a few of them that have delivered good returns as I noticed with the BTop 50 index, which is the twenty biggest firms in the industry.

Since 1990 there have been seven negative years. Six of them have come since 2009. So, yeah, you’re right. The majority don’t seem to be adapting well, but there are people who truly find unique ways of dealing with this. In a sense, I feel that investors are, unfortunately, going for the classical cheap solution, not knowing that they are leaving all the returns for others just because they charge a little bit more. That’s really unfortunate for the end investor.

Nigol

Sure, retail always looses. I don’t think CTAs are going to break that rule. So, the more convincing (in a certain period) that an investment is, the more likely that you’re going to lose money. This is why sophisticated investors, at a certain level, are able to stay ahead of the market and allocate when a strategy is losing as opposed to trying to chase returns. Chasing returns, which feels amazing (and you can have anybody do it), typically is counterproductive.

So, a lot of our brain is designed to chase returns like on a strategy level, or an investment, or bitcoin, or whatever. So, on the upside of a bubble, it’s easy to convince people to come in.

There’s a delicate balance. This is where you have to know yourself and know where you’re coming from and realize that the scientific approach to investment is not the same as the scientific approach to an external process which is independent.

Investing is a very complex process where your perception of the market affects future returns. Your perception… Because our brains think contagiously, so this means that if I’m thinking something or if I feel something, everybody in this room is feeling the same thing a little bit.

Especially in the investment world, it’s very contagious. People all believe the same thing at the same time, and there are major cycles that happen. To be able to isolate yourself… So, first having all the techniques in place – that you’re evaluating the scientific aspects of an investment the way that consultants do, that’s not enough. Then you have to go further and have a certain courage to invest where nobody else wants to allocate at that point in time. That requires a certain aspect of self-knowledge.

The requirements to be successful in CTA investment are not the same as other aspects of life. So, it requires certain personality characteristics which, I would say, are not common. People have to take those into account if they’re allocating to smart beta. Otherwise, it’s going to become the same losing game over, and over. You can use what investors think as a contrarian indicator.

Niels

What about…

Nigol

Let me add one thing. Smart beta or the longer-term indices haven’t done well, also, because of the opportunity set. It’s been a very, very extreme macro environment.

Central banks have about twenty trillion in assets globally that they have bought and continue to buy in the last couple of years, so the lower the vol., the bigger the impact of crowding. When the vol. expands the stops become more spread out, and there’s much more liquidity available for the typical trend following models.

I don’t see the fact that CTAs have had six negative years out of seven, in the last few years, as a negative if you take convexity into account. Again, you’re long on option, and you’re still getting it cheaper with long-term CTAs then you’re getting it buying it directly in equities for example. It’s still valuable.

Niels

Yeah. I want to stay on a topic. I think 2017 probably was the year where, to many investors, VIX really became known. Everybody suddenly talked about the VIX, right? And there was a little bit under the radar beforehand. So what’s your opinion, what is the impact of the growth of VIX volatility trading in our industry, but maybe also outside the industry?

Nigol

Sure, so certain investments that don’t have great risk-adjusted returns can temporarily turn into amazing bubbles because the return stream has certain characteristics which give time for other investors to come in. So it becomes very self-reinforcing like a positive feedback loop.

There are ways, in certain industries, where you can reinforce that intentionally. If you’re an activist investor, you put on a position and then you say, “Here, I got my position,” and other people come in, you can do great.

Effectively, it’s like a pump and dump of penny stocks in the eighties. Crypto currencies are a little bit similar. I’m receiving text messages saying, “Buy this, only this much for each account or whatever” So, effectively these things are being a little bit manipulated.

In the same way, regulators, if they don’t control these things, it can be very, very harmful for investors in the long-term. In the case of the VIX, starting from the Fed put, starting in 2009, which was that the market was not going to go down fifty percent anymore. It’s only going to go down twenty.

Then you had equity hedge funds which said, “Since it’s going to go down only twenty then I’m going to buy at minus fifteen.” Then, because the minus fifteen is there, then you had short-term swing traders who bought at minus ten. Then you had short-term CTAs who bought it at minus five, and then you had artificial intelligence or machine learning techniques who said buy it at minus three.

So, it’s become very self-reinforcing where effectively people are now justifying that the economy is doing great and that’s why the vol. is low. There’s an aspect of the reality that is that markets lead the economy and not the other way around.

I would say, today, what’s going on in the equity world, and the VIX, in particular, has become a very self-reinforcing bubble which is suppressing the vol. in the market. So when an implied vol. in the market comes down; when people sell options in the market until those options expire, effectively you have mean reversion trading.

If the market goes down, the options sellers are buyers of that market that is going down, and the option sellers are sellers of the market when it goes up. So they suppress the vol. of the market.

Typically, that lasts until the options expire. So, look at the open interest in a market. What drove the implied vol. compression? With options of this maturity, that’s typically when you’re going to see the mean reversion of the market. Then it typically breaks out.

So the VIX is quite a serious thing because a lot of, I’m going to say, very sophisticated investors are putting large amounts of money at play in it. Based on volatility and normalized risk techniques they think they’re taking very little risk.

Niels

On that note, Nigol, you mentioned the word manipulation, there’s the VIX, you talked about big trades, and so on and so forth. But, I think there was an article in Bloomberg recently that mentions that on December 20th of last year, 2017, the “VIX elephant” put on a very large position – something like two hundred and sixty thousand lots.

The article went on to talk about how relatively easy it is to manipulate the settlement, which has a huge impact if you’re trading options and you’re waiting for expiring, etc., etc. Do you have any thoughts about this?

One of the things that our industry has always been known for is liquidity. We’re not manipulating markets. We’re not creating trends. We’re not doing anything like this. The VIX seems to be a little out of the ordinary when it comes to this.

Nigol

(Laughter)The VIX, by the way, in 2017 there was a six month period where the Sharpe Ratio was fifteen. On the Euro VIX, it was thirty. So, yes it’s a little bit out of the norm. I would say about one hundred times over.

So, with volatility, the amount of risk or the amount of gamma that you have in the market is highly variable over time as you approach expiration. So, you come in and you say, “My vol. is this, and my delta to the market is that,” and then as you approach expiration, your gamma, or the level of mean reversion that you are willing to do, or the amount of liquidity that you are effectively providing to the market, increases exponentially.

I would say, in particular, it’s easy to manipulate the VIX. Today in an industry that, I would say, there’s potentially some misalignment of interests between the interest of hedge fund managers where they participate in the up side but not the downside towards year end. There could be quite strong incentives to make sure that the market stays where it needs to be for a good payout year-end.

So effectively, if consciously we’re talking about risk being volatility based, and I say that my position is this (and I have a ten percent vol. and I’m going to keep a ten percent vol. and short the VIX), you’re going to create this bubble very, very easily in the VIX. You don’t need to do this on the VIX.

If you look at equities, if you look at fixed income over time, or the all-weather portfolio, or risk parity (where positions are inversely sized to, let’s say one year, three year, five year vol.), the fact that people are allocating to equities, and the vol. is coming down, they are constantly increasing their leverage and they are reinforcing that cycle. The leverage today, in a ten vol. risk parity product, is six to one, where, at a peak in 2007 it was four to one. In 2003 it was about four to one as well.

Today, just the fact that people are chasing or saying, “We agree I’m going to put on ten percent vol.” “You don’t complain,” it’s stated. Now I go do this. In the market, if I do it in a way that I’m timing my entries correctly, I can suck in a lot of quantitative traders in the process.

I’m saying that, in the VIX, it’s very easy. Even in equities and fixed income you have the same thing going on. If you buy the S&P when the realized vol. is low, you typically lose money. If you buy when the realized vol. is high, you typically make money.

Effectively you can use only volatility as a way to time the S&P or equity indices just because of the way that people are trading it and the way that people are sizing their positions.

Katy

Do you trade the VIX?

Nigol

We put on tiny positions, as I said, mainly for entertainment. So, we can extract convexity out of the market by trading delta one futures. We don’t need the VIX to get that. If we want the negative skew, we can generate negative skew by trading delta one as well.

So, models that bottom pick the S&P have Sharpe Ratios of four and five in the last three years. Again, we provide those for free. You can get that convexity without trading the VIX. We trade it almost with a smile.

Niels

So we started out the conversation today talking about 2017. It was a difficult year; you learned a lot; lots of meditation and all of that stuff. I’m assuming that you adopted or evolved or innovated during the period to essentially overcome this low vol. or the compression of volatility.

So how do you change a model like that without losing what your original profile and what you’re known for and to be able to actually make good money in a period where the S&P is still going up?

Nigol

Yeah, that’s the million dollar question.

Niels

Yes, so I’m glad we get that in now.

Nigol

So obviously, oh you want to adapt? “Did you learn anything,” the investor tells you. No, we questioned ourselves substantially. We continued to believe that we’re aiming our strategy for a slightly higher level of vol.

So, we adapted but not by taking away our positive convexity. The way we adapted is by seeing what type of noise is actually happening in the market. So, instead of trading certain timeframes, we’ve diversified our timeframes where the typical noise…

So suppose you are running a three hundred day moving average. If the market goes up for thirty days and comes down for thirty days, then you are exactly on the opposite cycle.

By diversifying the timeframes that you are trading short-term ( going more intraday and slightly longer-term rather than more focused daily frequencies), you’re able to evolve and be less vulnerable to a type of noise which is in one frequency – which is what happened in 2017.

So, first, we diversified the frequency that we’re trading in the short-term. So instead of three days per trade, we’re trading six hours, twelve hours, thirty hours, that type of thing. Second, is that we added a mean reversion component. So instead of being one hundred percent long momentum we’re trading one-thirty long, thirty percent short.

So, effectively we’re saying we want to provide liquidity in the market at certain times in order to hide our footprint. So, as I mentioned, you can be momentum mean reversion neutral and provide liquidity at the same time that you’re taking it at different times of the day and at different prices. So, we’re doing some of that effectively.

So, we increased our momentum and added some mean reversion because there are such obvious convexity plays on the short side as well. So we diversified in the same way that an equity long/short can typically achieve a higher Sharpe Ratio than the equity market alone.

Niels

Yeah, and if we go back to the, maybe we can call it normality because maybe we feel that this current environment is unusual. If we go back to normality would you then have to adjust back to the way you used to do things?

Nigol

No, our convexity today, our expected convexity, is the same that we have had over the last twenty years. By playing with timeframes, you can be trading as much mean reversion as momentum and still maintain your convexity. Effectively, it’s a play of timeframes, so you can be beta neutral, but the sizes of your exposures can be quite different.

Katy

Nigol, you talked a little bit about filtering. Could you maybe clarify more about how you think about that and what you mean by filtering?

Nigol

So, filtering is like the Holy Grail. Basically, the alpha comes from filtering. So, filtering, fifteen years ago trade momentum or trend following occurred only when the vol. was compressed. That’s one way, that’s the way it was.

Then maybe five or ten years ago it was trade momentum in the direction of the negative skew. The skew in option pricing tells you that, effectively, if a market starts to go down there’s going to be a trend. There’s going to be a very strong drift.

If the S&P starts to go down today, the market is expecting that it is going to lose twenty percent a year – that type of thing. So that’s another way of filtering. The market is telling you that if we go down, we’re going to go down a lot. So you say, OK, we’ll go along with you, no questions.”

Katy

So do you thing that there’s more that you need to spend more time thinking about that in today’s markets as opposed to a few years ago? Is that the secret sauce, I guess we might say?

Nigol

There’s more clarity gained not around the way the markets are but by the way that people trade. I don’t believe that the markets are a certain way; that if you’re long the S&P you make seven percent a year, and if you’re long CTAs you make ten percent a year. It depends on what people are thinking and the way that people are trading.

The way to (on the run) evaluate the level of conviction and risk people are taking means asking, “Where is the surprise potential?” So vol. compression was fifteen, twenty years ago; convexity was five, ten years ago. Today a lot of what we do is around crowding.

Effectively trade against… Whatever feels good, do the opposite. (Laughter) You can do this looking at the relationship of the between the returns of different sectors within momentum. You can look at certain markets within a sector and assume that things are going to mean revert.

Katy

So if it’s uncomfortable that’s a good thing.

Nigol

Correct, if it’s uncomfortable or… The way that we’re programmed to think… How does the way we are comfortable thinking lose money? That is why we bet on that.

Today, you can hire people who are undergrads and who can run optimizations that quadruple PhDs couldn’t do twenty years ago. The techniques available for optimization are lacking – they are not free. As a result the ways that people are chasing returns, and therefore reinforcing short-term bubbles and then breaking them down (how the markets de-pattern themselves), are really critical and has changed.

Our job is to find ways to provide this convexity with positive alpha at the same time by relying on what people are comfortable doing and trading against it. In all timeframes, it’s available. You can hire ten quants, and they all tell you the same thing, and you do exactly the opposite.

Niels

Is there a risk, in some ways, that…

Someone shared this with me, and I thought it was interesting. If you look at the European part of our industry, and you look at the US part of our industry, there is no doubt that in the late ‘90s (I think) the Europeans, the managers were seen as being more scientific. Therefore, a lot of institutional investors preferred that over the US managers who were seen more as ex-floor traders who systematized their rules – whether it be Turtles or someone like that. But, it also meant that a lot of the European managers were recruiting from universities to emphasize this scientific approach to investing.

Of course, as we know, in the universities they teach from the same books. So, their approach to (for example) risk management is, perhaps, more similar than what we think in that they start looking very similar. I don’t know, it’s not a study that I’ve done, and it’s not a right or wrong, but you’re saying is, do a little bit the opposite, be the rebel. In a sense, if you recruit from the same university and they all end up doing the same thing (maybe that’s not down the route yet, obviously with a few exceptions), that’s a lot of money still flowing to those types of strategies.

Nigol

Sure, there are two aspects to that trade. First, universities don’t teach you what you need to know; they teach you what recruiters want you to know in order to go sell their products. So, it’s not necessarily the best knowledge available. You know how it works.

The next phase is the scientific phase where are we progressing scientifically in everyday life? Again, investing is not something that can be managed through a scientific process – absolutely not. It’s a complex system where high conviction results in the pattern breaking.

So if you hire a scientist who says, “People who wear white shirts typically go to the beach, and people who wear black shirts are going out” (whatever), you can do that in everyday life. It doesn’t affect the process, but in investing, the more advanced… With science, you need to do it just to understand what people are thinking and feeling, not because it gives you an idea of what the markets are going to do. It’s very different.

When everybody believes that buying the S&P after two down days is a one hundred percent trade or a ninety percent trade, the market de-patterns. Science is not very good at figuring this out unless you’re looking at the science of the mind (we’re getting there).

Another way for us to measure this is the level of conviction that people have in certain trading strategies. So, you evaluate the behavior of the returns of different trading strategies, and that tells you how the people trading these are feeling based on the Sharpe Ratios, and you can do certain things with that.

First, education is not ideal. It’s intentional; it’s not pure knowledge. Second, they are cyclical, and science will not understand markets. Depur Neuton, I think, was a good example of that.

So, you cannot have a purely rational mind when you’re trading. You need to realize the cycles of emotions that investors are going through. At a certain stage that might change, but the frustration today…

So the people are saying, “I want to invest with quants,” that is because they are frustrated with the macro managers who haven’t done anything because central banks have made it impossible for them. That’s, again, a cycle where people will run away from quants and go back to the thinkers one day.

Niels

Absolutely. As we head into 2018 with all the changes that we’ve seen from different areas and certainly how it has impacted us, we already talked about the markets and different trading strategies. What are the opportunities that you see? How do you think about that?

Nigol

It has never been cheaper to hedge, and today you need to have a very, very disciplined process. Relying on the recent returns as a way to predict the future is going to be very, very difficult; very painful and highly risky.

Today I would say that investment has to be a process. We need to allocate X percent to CTAs. I know they’ve lost money, I know I don’t like them, I know they have no beautiful story that I can tell my investment committee, but CTAs are still a very, very valuable part of any portfolio even with flat returns over seven years or whatever it is. That needs to be understood, and I need to stick to that discipline.

In the market, what’s happened since 2009 has been a one-sided thing. The Sharpe Ratio on the S&P is something which has been unseen. The S&P is up fifteen months in a row. That’s unseen; it’s never happened. These types of things create extremes in certain types of behavior in the market where CTAs are very, very well placed to take advantage of.

I see that central banks slowly starting to pull liquidity away from the market is the first step of that reversal, going into a regime where CTAs might make a lot of money for many years in a row. That’s very important. That’s the major factor that I see as the opportunity.

Katy

So, going the other direction, because you focus on the things that are uncomfortable – the tail risk out there, what are the things that you think are the threats? What are the things that keep you up at night – the worries, the things that maybe people aren’t thinking about that you think are important?

Nigol

For CTAs?

Katy

For CTAs and markets in general, given your position.

Nigol

Crowding is much more than people think and much more than people want to admit because they don’t want to scare investors. So for us, we’re thinking so much in those terms, and quite the opposite, we’re telling investors that the markets are really not liquid, and this is what we see. It’s obvious.

It’s almost like you can be manipulating a stock and not tell your investors and say, “By the way, we’re manipulating a stock, and we can see it, and we’re doing it carefully,” or whatever. What we see is that CTAs have a major impact on the markets, especially short-term.

We want to be transparent. We want to be honest with ourselves. The more honest that we are with ourselves, the more clarity we have in terms of how to deal with it and move forward from there. For me, that’s the real danger.

Ten years ago nobody believed in CTAs. Nobody knew how to replicate a CTA. Today we provide a replicator for free to everyone as a formula. Today, as CTAs start to make money, it’s possible that you’ll see major inflows. So, we have to catch up whether the liquidity of the market is really there or not to support that type of trading. To me, that’s the real driver of performance.

You cannot be just smart beta. You have to, at some stage, say that certain places convexity is too expensive and you want to actually be shorting it.

Niels

I want to add something. I want to add one concern that I have, and that is because of the popularity of the smart beta programs and the flows into that because they are so similar. There are only very few ways that you can do basic trend following or replication of trend following, and I don’t think investors really realize the exit risk that they have in that space. It’s, for me, definitely a concern to see that that part of the industry is growing so quickly just because it’s cheap. So, anyway, it’s not really about me.

Nigol

It’s actually worse than that. It means that when the market is going to go up if you look at channel breakout systems. In a lot of real trends, let’s say a twenty day high, the market makes a twenty day low and a twenty day high five days later. You have very specific things going on in the market.

In terms of cheap or expensive and which is better, you need to be aware of how expensive it is to have the comfort of transparency. So, investment committees should know that. By the way, we’re aware that it’s not a question of if it’s transparent and it’s cheap. You need to make sure that you realize that the fact that it’s transparent and it’s cheap is going to be a factor which is going to give us a higher likelihood of negative alpha. When investment committees know that…

Niels

They’ll think twice.

Nigol

They’ll think twice. I’m not saying it’s bad, but they have to know.

Niels

They have to know it. It’s part of the decision, I agree.

Nigol

I still would allocate to smart beta.

Niels

So, let’s turn it the other way around. What’s the best question these investors could be asking themselves right now?

Nigol

Really again, in today’s world I don’t know how investors can evaluate hedge funds or CTAs without looking at multiple levels of convexity – different measurements of convexity. I have no idea how they can do that. There’s zero risk otherwise.

So, to me, that’s the most important question, again as I said because it drives the size of the drawdown. How many times your vol. that you’re going to lose depends on your level of convexity – investors should know that.

Also, how to evaluate alpha which is convexity base versus alpha which is skill based. Skill-based alpha is stable; convexity based alpha is not. To me, again, convexity – I’m using it as a simple word, but there are many ways of doing it. Investors should be desperately looking to understand that factor.

Katy

So, if you had one final thought to leave to investors.

Niels

And you couldn’t use the word convexity.

Katy

And you can’t use the word convexity. (Laughter) What would it be, what would you have?

Katy

You can use it, we were just kidding.

Nigol

There’s a quote, it’s, “We have met the enemy, and it is us,” something like that. In the investment world that is more true than anywhere else.

Niels

Always, super interesting and inspiring to have you on the podcast. Let’s, on that note, wrap up this fascinating conversation recorded live here in Miami. Nigol thank you, so much, for being on the podcast and for sharing your thoughts and experiences with Katy and me. It is so important that practitioners, like you, come and share these ideas because when ideas become conversations that lead to action, that’s when real change happens.

To our listeners around the world, let me finish by saying I hope you got a lot of value from today’s conversation and that you enjoyed it as much as Katy and I enjoyed making it for you, and that if you did, please share these episodes with your friends and colleagues so that the conversation can continue.

From me, Niels Kaastrup-Larsen and Katy Kaminski, thanks for listening and we look forward to being back with you on the next episode of Top Traders Unplugged. In the meantime, go check out all of the amazing free resources that you can find on the website.

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