“This is a long term permanent component in a portfolio that ought not to be considered as a timing device for extracting some additional alpha.” – Aref Karim (Tweet)
Aref Karim has been on the institutional investing side and the fund manager side for many years, so he has some great insights into how each group thinks and ways they can understand each other better. In this episode, Aref reviews 2014 from the perspective of QCM and discusses the research upgrades that the firm started to their program, and how they dealt with the events of the year, including the recent Swiss Franc move.
Thanks for listening and please welcome Aref Karim.
In This Episode, You’ll Learn:
- About the two programs that his firm trades.
- How 2014 went for Aref and his firm.
- About the upgrades that the firm started in late 2013.
- Where their largest gains came from in 2014.
- The opportunities that no one predicted in 2014.
“We’ve had some opportunity costs, and those gave us a chance to see how the simulations would have done.” – Aref Karim (Tweet)
- How they dealt with the Swiss Franc move in early 2015.
- How institutional investors are looking at the managed futures space as we enter 2015.
- What 2015 looks like for his firm.
Resources & Links Mentioned in this Episode:
This episode was sponsored by Swiss Financial Services:
Connect with Quality Capital Management (QCM):
Visit the Website: www.QualityCapital.com
Call QCM: +44 (0) 1932 33 44 00
E-Mail QCM: email@example.com
Follow QCM on Linkedin
Aref: We've had some opportunity costs, and those opportunity costs gave us a chance really to see and compare how the simulations would have done essentially, and sure enough those would have picked up those trades. In other words, I guess our gains would have been enhanced further… As you know, the industry's done greatly in 2014, and it's nice that for us, in the end, we've come up with still fairly decent numbers. But yes, there was an opportunity cost in terms of we could have done better.
This is Aref Karim, Founder and CEO of Quality Capital Management, and you're listening to my year in review on Top Traders Unplugged.
Introduction: Imagine spending an hour with the world's greatest traders. Imagine learning from their experiences their successes and their failures, imagine no more. Welcome to Top Traders Unplugged. The place where you can learn from the best hedge fund managers in the world, so you can take your manager due diligence, or investment career to the next level. Here's your host, veteran hedge fund manager, Niels Kaastrup-Larsen.
Niels: Welcome back, Aref, for this review of 2014 where we look at the big events from the point of view of your trading strategies. I would like to explore the ups and the downs as well as the big takeaway from what can only be described as a great year for systematic trading strategies, in general. But as you and I know, just because you're systematic in your trading, it doesn't necessarily mean that your strategy deals with the market events in a similar way. But before we jump into the year and such, I would like to ask you to remind people just very briefly about the two strategies that you run and the difference between them.
Aref: Thank you Niels, thanks for having me back!
Niels: It's a pleasure.
Aref: Yes so the two offerings we have: one's the flagship which is the Global Diversified Program, and that's pretty much descriptive and says it all, that it is a very much diversified program in the line of what most CTA's trade. Effectively you have equities, fixed income, currencies, and in addition you have commodities. The Alpha Financials Program was basically designed or came out of a specific mandate that one institutional investor had requested of us back in 2012. That essentially trades everything other than commodities. The underlying strategy is very, very similar. However, people often think that it's a carve-out. It isn't a carve-out as such, the reason being that the performance is not as though if you just took commodities out and put the rest together... Say it's more because of our nature and style of trading, the overall returns can be somewhat different.
Niels: Sure, absolutely great, I appreciate that. Now tell me a little bit about 2014 from your perspective, both in terms of how the year evolved for the strategies and maybe also for the firm as a whole.
Aref: Yes, 2014 for us, having had quite a setback in terms of assets (as has been the case with a number of managers within the industry)... We were in the process of a kind of re-vamping and focused all our efforts in terms of keeping the infrastructure side fairly similar; somewhat downsized, but with a lot of focus on the research side. So what started in late 2013 as part of an upgrade in our overall systems and strategies, we continued through the course of 2014, and then in October 2014 we put in the last set of upgrades to complete what we would call a reasonably major review of our strategies. Which we feel have in some ways demonstrated into the last quarter, although there has been greater opportunities there, but those upgrades have demonstrated the capability of the more enhanced strategy. So we're looking forward to the future really in terms of utilization of this.
Niels: What was the focus of the upgrades Aref, if I can ask?
Aref: Yeah, so we back in 2013, we effectively got rid of an indicator type of an approach, in terms of determining directions and markets, which I think I touched on in the last interview.
Niels: Yes, you did.
Aref: Which makes us somewhat different from most managers who tend to use, as you know, some sort of directional indicators: whether it's in the trend following world, it would be breakouts, or averages, or regression analysis of some sort. We've kind of moved away completely from using any of those, and we've had a volatility driven kind of approach that we designed back in 2005. We empowered those considerably more so that the direction part of it is also in a way determined by that. In other words, rather than focusing on whether a market is going to go up or down and then deciding on what weight to place on it, we've almost flipped it around. What we sort of focus on is more the weighting element, and then the volatility part kind of corrects forward the directional aspect of it. So it is completely inverted, and that makes, we believe, the strategy a lot more adaptive and powerful. It's kind of in a way based on really asset allocation, but to the shorter term context let's say risk allocation. So it's pretty dynamic and fluid. We don't have to worry about whether a certain price trigger is gone on the upside or downside and flipping signals. It's very much a continuous rebalancing portfolio exercise.
Niels: Sure, very interesting indeed. Now both of your programs had a good year last year. If you look at them maybe separately, what were the biggest contributors both on the upside and the downside during 2014?
Aref: Yes, so the upside again, taking if you like the overall high level allocation trade was in our case essentially played out by being basically long US, and essentially short the Europe and emerging markets. And that kind of in a way will manifest itself by sort of being long the US dollar. Our largest gains, actually, came from the deflation trade in Europe and those through Germany in particular because of the problems that have been unfolding in Germany, and the expectation of QE, etc.
So that's kept the bonds, for example, German fixed income very strong. And in fact when we look at the attribution returns beyond the sector level into the market level and find that the largest gains have come from the German kind of fixed income across the curve from the Euribor, to the bonds, bobls chats, and also UK. The fixed income guilds provide handsome gains for us and so did short sterling from the fixed income part of it.
The rest of it has been… We've kind of kept the hedge with our long equity position through most of the year. The equity positions have actually cost us, but that's okay, that's part of the hedge if you like, against the gains of the fixed income side of it. The other bigger trade has been the long dollar trade. Now admittedly we've been a bit late in coming into the long dollar play in a more aggressive way as we did towards the latter part of the year of 2014. Part of that has been the slowness from our side in terms of implementing those enhancements, the upgrades that I mentioned earlier. But anyway, that's been put right, and we enjoyed at least the last quarter, particularly November, December and continuing on, January has been going fairly well.
Niels: Sure, and did you see the same sort of pattern to the year as many other people, where actually Q1 was quite challenging and then slowly got better and then really accelerated towards the end of the year?
Aref: Yes, I think Q1 for us in the Diversified… We were down about three, four percent. And then in the middle… The second quarter was reasonably positive; that was good. The third quarter was again a little bit up and down, July was down three, August was up five, we probably underperformed in August relative to other managers. And again when we look at the simulations based on our upgrades, we would have done better. But anyway, that aside… But the big chunk of the gains in fact came on the last quarter in November and December when... Another trade, I forgot to mention was on the commodity side of course with oil, collapsing from mid-June from one hundred bucks to fifty, sixty percent drop. That was very helpful for us as well from the short side.
Niels: Yeah. Now the year as a whole, you mentioned there were some big moves, and there certainly was in many of the commodity markets. I was not so much going to… I mean I've asked some of my other guests about whether they felt there was anything, when looking at the year as a whole... Obviously people when you make money you don't necessarily focus on the negatives but actually we should always focus on where we can improve, where we can learn. But I was more interested in finding out whether the year as a whole, given the fact that you had so many new things that you wanted to implement, and indeed did implement, was it more a year for you to validate those things that you'd been working on in a sense?
Aref: I think so yes, I mean the… When I look at the simulations of our strategy for how 2014 would have panned out, I guess where we would have made significantly more gains, as have a lot of managers in the industry, would have been in the FX side, particularly the long dollar play because we would have probably gone in a bit earlier rather than so late. So that was… So we've had some opportunity costs, and those opportunity costs gave us a chance really to see and compare how the simulations would have done essentially. Sure enough, those would have picked up those trades. In other word, I guess our gains would have been enhanced further.
As you know, the industry has done greatly in 2014. It's nice for us in the end we've come up with still fairly decent numbers, but yes there was an opportunity cost in terms of we could have done better. I think that at the macro level, the top level, our… The power of the strategy kind of in a way manifested itself in being able to selectively pick out Germany and certain countries for those gains. It's been very opportunistic in coming in selectively into the energy sector, in particular. Of course, that was an extremely strong momentum base trade, which everybody picked up on. Or even, for that matter, being live along the livestock's in the early part of the year which has been pretty good, cattle, etc. And that's been one big macro trade for us we just stayed long for an extended period of time.
Now those things could have been a lot more powered up if you like, with the enhancements. But overall I think that the commodities sector or asset class as a whole continued to be challenging other than these opportunities that we've had. But metals, as you know, have again, been quite a difficult one to play out. And this is validated by when we look at the commodities index for the fourth year in a row, it's just been negative. So it just shows that when the beater is kind of treading away in a very gradual, you know, way… It is very, very difficult for long vol type of strategies to come in and kind of… You know we tend to like those moves like obviously oil doesn't come around every other day, it's a rare one. But you know, when they do, you want to make sure you're on that trade you know. As you know with CTA's and these kind of long vol strategies, often times the returns come in a lumpy fashion. For a while this is fairly quiet and then it's got the huge optionality that just provides that explosive opportunity if you like.
Niels: Sure. You make some good points here Aref, which I just want to reiterate namely that some of the best opportunities in 2014 were really opportunities that no one talked about, no one predicted… I mean, you don't read the news and say, "Oh, I think cattle is going to be one of the best contributors in the coming year." You certainly didn't see any expert coming out saying that oil was going to drop by fifty percent.
Another theme that nobody has really has talked about or anticipated was the decision on Thursday from the Swiss National Bank to decide to leave the peg to the Euro. So let's stay with the theme and shift to that particular one. How did you fair through such an event which at least if you look at sort of the traditional way of calculating volatility and standard deviation and so on and so forth, this was a move that in theory should never have happened, yet it did. Which of course as a strategy, we are prepared for. But how did you specifically deal with a situation like that?
Aref: Well, ours is a portfolio so... Obviously it's fairly well diversified in the context of the Diversified Program with one hundred and fourteen instruments. Now, the Swiss markets do play a part in the portfolio, We have SMI, the equity index, we have the 10 year bonds, the confs, and then we did used to have in the past the Euro/Swiss which we dropped out when rates went negative… what is it, two or three years ago? And the Swiss franc obviously is a currency that we continue to trade.
Now the move itself, as we all know, was a real shock move. I mean it was just unexpected. I think that people are still questioning the execution of that decision whether it was done in the right way, why not just move the one-twenty up-ceiling down to one-ten or whatever, rather than just opening it up completely you know. It was a real shocker. Now going into the day, I think it was Thursday, going into the day we continued to remain long on the SMI. We had been pairing back our European equity position for a while now. In fact, when we look at our asset allocations weights if you'd like, over the year… We started about thirty, forty percent over our risk budget in equities at the beginning of the year, and we ended at about… Well, now it's about eighteen or so. We're probably around twenty percent.
So we had been scaling back. However we still had a long position in the SMI as we have across the board in equities. We continued to hold a position in the Swiss bonds which is doing well, and we were short the Swiss against the dollar as most people would have you know. So that spike… What is it, thirty, forty percent in the currency at one stage. Now it is an intra-day spike, our positions, not been large in the scale… in a relative basis in this… relative to the overall portfolio.
So overall, yes we lost in the Swiss trades that we had, about two to three percent, but we made in the other fixed income other trades that we held in the portfolio. So that net-net on the day we ended with just being down fifty beeps. So you know, and that's fine, that's… Given the magnitude of that move, the fact that a portfolio is so well insulated though diversification and through having our fixed income across the board. So the damage was not too bad. Then we just let the portfolio align itself. So obviously you mentioned a vol, and extensive vol, so that's going to… But it's kind of after the event obviously because no one was anticipating that. So you know, those positions will be scaled down to probably negligible amounts within a day or two.
Niels: Sure, no I appreciate that insight. Now because of your experience Aref, I want to deviate a little bit from my usual questions during this review because I think that this is something you might have a view on which I think could be quite useful. Given what's happened, and let alone what happened on Thursday, but given the events of last year, given the fact that CTA's as a whole had a strong year in a year where there were no disasters… They didn't make money because certainly the world was coming to an end, and equity markets were crashing or anything like that… If you put your old investor hat, which of course we all know that you were wearing for quite a while, and I'm sure you still keep in touch with many of these very large institutional investors around the world. Do you feel that the conversation or the attitude was or is changing given that we saw these events last year, given the way CTA's or systematic strategies were coping with them, and maybe also in relationship to the fact that some other strategies weren't coping so well? Did you feel that investors are noticing this and becoming more interested again?
Aref: Well I think as you know, I've been a great advocate of the managed futures space for years and years, and I believe in it passionately. We know all investment strategies that do go through periods of being un-synced if you like, and being underperformance follows. Obviously nobody expected that the length of this underperformance in our managed futures strategy would last as long as it did. But once again it brings home the role that managed futures really play in any portfolio. It shows that how uncorrelated this is… I mean when you look at 2014, you look at the… Consider the huge uncertainty that the rates kind of area played in everybody's mind. Consequently, with that nervousness, a lot of the managers in fact (and I'm talking about those discretional managers, not obviously the systematic ones) probably in a premature way started to scale back on fixed income, anticipating rate rises. And quite rightly, because the Fed was making confused noises, etc., and almost suggesting that that was going to happen earlier than later, sooner than later.
Then when the numbers started to come out and then they kind of almost backtracked from the whole thing. So they missed out on the fixed income trade. And when I look at our own portfolio, for example, and I look at the attribution, the huge by far, the most significant part of the gains have come really from fixed income. That too again selectively from the areas of fixed income of the regions where things were going slow and slower still, slowing down still so that… In Europe for example as I mentioned earlier, so that was really... Now these kind of bets that tend to kind of opportunistically be picked up through managed futures and our type of strategies by having the nimbleness etc., and not almost predicting things, and just on the fly correcting your portfolio to suit whatever's happening in the real world. It just shows that that component, that element in any portfolio is required where there is an element of agnosticism, if you like, that you can put in that brings a non-correlated feature into the portfolio.
You're not in the game of trying to predict how things are going to pan out next year, and almost let the markets find their own way and determine the positioning of a strategy. This is where managed futures have been excellent through forever. I mean... And 2014 again shows the way… I mean some managers have done exceptionally well, just fantastic. That's great for the industry because it does hammer home the point that how important this strategy is in any portfolio. So yes, long answer to the question, but the thing is that yes I do think they ought to, and I think that they are. Institutions will again look at the strategy and say, "Okay, they were late in getting out and now hopefully they will be fairly quick to correct that."
Niels: Yeah. But more importantly I guess, if they do come back and if we do see a new inflow and maybe in big size given the fact that probably most investors are really underinvested in this strategy. This, I guess, is proven by the fact that only two percent of the institutional investors that were asked at the end of December 2013 which strategies they would expect to do well in '14, only two percent said CTA's. So I imagine that the other ninety-eight percent probably aren’t great supporters of the strategy. So to me there is this risk that we see another repeat of the inflows at least that we saw after 2008. Given your experience Aref, how do we best avoid, how do we best caution investors as they do start to make new inroads, about the strategy or the expectations maybe to the strategy so we don't see the big rush in and the equally big rush out?
Aref: Yeah, I think that the most important element of it is the… Trying to almost emphasize and establish the fact that this is a long-term permanent component in a portfolio that ought not to be considered through a… as a timing kind of device for extracting some additional alpha. In other words just finding the right cycles and say, OK, CTA's are going to be great in this cycle so bring those… Because inevitably you're going to get it wrong. The reason you're going to get it wrong is because we ourselves don't know when the next move is going to take place and how it's going to come about.
Yes you may have some expectation. At the end of the day if you're running a systematic strategy, those expectations mean nothing because they're going to be overruled by the algorithms, and you need to follow that. Now in our case obviously we try to make a little bit more macro fundamental so that there's a little bit more intuition into it. But coming back to this is also that we need to… It's a process of, I guess education, and I say education in a humble way and not because everybody knows about these things.
But what I'm talking about is really emphasizing, reemphasizing through thought pieces, etc. on how important this strategy is, and also, giving some transparency into the strategies. Because let's face it, as an institutional investor one of the big put-off factors for CTA's and managed futures is really the fact that they just don't understand it. It's almost like being sold in a black box and just saying essentially you're expected to buy into numbers, and that's the last thing that they want to do. They want to get a real sense of what is going on, how does a strategy work. So that gives them comfort as opposed to just buying into a system without really knowing much more than to say, okay, it's trend following, or mean reversionary, or pattern recognition, or whatever it is.
Niels: And on top of that I would add that hopefully they would also spend enough time to get to know the managers. At the end of the day numbers don't mean anything if you don't know the story behind them, so definitely do that.
Aref: And it is a bit of a challenge because as you know most managers tend to try and keep their strategy very close to their chest. Quite rightly because it's part of their IP, They spent many thousands of man hours on developing these things and you just don't want to give everything away, you don't want to give your edge away. So it's a fine balancing act in terms of being able to still make an investor feel comfortable: that there is enough there for them to get a good intuition into the strategy without necessarily giving all the nuts and bolts away.
Niels: Sure, no absolutely. Now I've only sort of got one question left for this short episode. Is there anything that you would like to bring up that you think is important to mention to the listeners today as we sit here and look into the New Year?
Aref: Well I think that the New Year is going to be exciting for us. The trade we're looking at again at a macro level is essentially continued to remain long US, which is the stronger more dominant economy, and continue to play the deflation in trade and the rest of the world. So essentially a short Europe and emerging markets… And in our case we would be playing it by combination of kind of underplaying and selectively shorting appropriate amount of risk assets and being long essentially fixed income rest of the world.
Again the US side, in particular, where there're chances of a rate rise, so we're going to be… Our systems are likely to keep a close eye on that, to make sure that weighting is lifted, and positions lightened up when required. But the… It'll probably manifest itself in our portfolio positioning by being long the US dollar, which we continue to… And it has to because there's a huge divergence in rates that are likely to take place. And now with the Swiss franc move as well, so that puts more pressure on the Euro. I mean Europe…
There're going to be great continuing opportunities I should say in currencies I think. We would probably continue to stay long fixed income, particularly Germany, again because of the deflationary environment, and with Draghi expected, I guess next week, for this QE moves. So, essentially stay long US fixed income but a bit more conservatively and a little bit more aggressively in Europe and Japan and the rest of the world where the deflationary pressures are still significant. And in terms of commodities, we're likely to stay relatively short to flat in commodities, and with opportunistic I guess long trades as we saw in 2014 in meats, for example.
So those are the big trades I guess, and that in a way reflects the state of the global economy in some ways today. So we're quite pleased to see that our positioning is just… The portfolios have just aligned themselves with that kind of a scenario. That being the case, I think for CTA's, there should continue to be opportunities there. Let's not expect any big growth, inflation type of trades. In other words, risk asset, like commodities soaring, etc. Although there is an argument for whether these markets have been beaten up so badly that perhaps they're posing to be… To provide some value at this point in time… Certainly oil, the way it was going up, probably find challenge at the forty dollar or so bottom. But it seems like it's picked up a bit, but who knows, it could just be a short-term reaction in the markets. But regardless I think we are going to see some volatility, so CTA's generally stay with the system basically. You've done well, we've all done well in 2014, and I think there are more opportunities to come. The more divergence you have in the global flows of capital, the more opportunities you're likely to be able to take advantage of.
Niels: Sure, and you're certainly not the only one expecting more divergence in the world, so I completely agree with that. Well, you know let's end it here because that was a great insight as well also to the New Year as investors look into that. And it is a short episode so… And of course if people want to hear much more from you anyways there is plenty of opportunity by going back and listening to our previous conversation on Top Traders Unplugged.
So I want to thank you again Aref, for being on the podcast, for sharing your insights. I want certainly to congratulate you and your team on a very solid year last year, and I want to wish you and your firm all the very best for 2015. I look forward to catching up later in the year.
Aref: Thank you very much Niels, and I wish you the best of luck! I see that the number of podcasts and the attention it's getting has been significant, so you're doing a great job.
Niels: I appreciate that. Thank you so much, and all the best. Take care, bye.
Aref: Thank you. All the best, bye.
Ending: Thanks for listening to Top Traders Unplugged. If you feel you learned something of value from today's episode, the best way to stay updated is to go on over to iTunes and subscribe to the show so that you'll be sure to get all the new episodes as they're released. We have some amazing guests lined up for you, and to ensure our show continues to grow, please leave us an honest rating and review on iTunes. It only takes a minute, and it's the best way to show us you love the podcast. We'll see you next time on Top Traders Unplugged.
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Date posted: 30 Jan 2015no comments