Co-founders Dr. Lukas Goetz and Michael Schülli bring years of shared experience to BlueBalance Capital, having first worked together when Schülli, on the sell-side at BNP and JP Morgan, provided investment ideas to Goetz at UNIQA Insurance Group, one of Austria’s largest insurers. Goetz managed the strategy within the company’s proprietary trading account and previously gained experience at a global macro-oriented family office while finishing his doctorate in finance. Partner Alexander Kahl also contributed to the strategy at UNIQA and has a strong background in various quantitative roles, including positions at Goldman Sachs and Deutsche Bank.

Following its initial seed investment from UNIQA, BlueBalance has grown into an independent team of nine, with six members focused on investment. The company’s name, inspired by UNIQA’s blue logo, also reflects the balanced approach at the core of its strategy.

Core principles of the strategy

“From the beginning, we had a broad mandate to trade global relative value within a strict risk framework,” recalls Goetz. The idea was to build an uncorrelated strategy across asset classes and risk factors, guided by three core beliefs.

First, while forecasting markets is challenging, market expectations are embedded in implied market parameters and can be exploited. “We capitalize on structural flow imbalances and dislocations such as irregularities in term structures, driven by behavioral biases – like hedging needs of insurers and pension funds – and constraints from siloes, mandates and benchmarks. Our aim is to exploit abnormal term structures and generate positive income in a way that is agnostic to directional market trends,” explains Goetz.

The second core belief is that diversification is essential and can be greatly enhanced by dissecting asset classes into their underlying sources of return. This is achieved by accessing OTC markets and deploying capital across a large number of risk factors, instruments and time horizons.

And finally, the strategy focuses on medium time horizons, with individual transactions typically maturing around 12 months. “This longer holding period reduces randomness and mitigates the impact of short-dated swings, thereby increasing the hit ratio of transactions. Many dislocations within this time horizon remain underexplored by other market participants that usually focus on shorter maturities, allowing for greater opportunities to roll along term structures. We will generally avoid anything under 6 months unless we see an extreme dislocation,” says Goetz.

Market structure, not fundamentals driven

BlueBalance’s strategy comprises three core components: macro, relative value and volatility trading. Each is designed to generate profits independently of market direction, supported by a hedge book that provides stability during times of stress without serving as a long-term profit centre. The strategy focuses on market parameters rather than direction or beta, following a scalable and repeatable approach to analyse a wide range of factors, including volatility, correlation, skew, dispersion, yield curve shapes, relative yield spreads, basis trades and dividends among others. To capitalize on identified dislocations, transactions are carefully structured – often through derivatives – to isolate opportunities and add diversification.

Dispersion, for instance, can be divided into volatility swap, corridor and down dispersion as well as options on dispersion. These variations capture different aspects of market movement, while diverse payout structures provide an additional layer of diversification.

The highly diversified portfolio remains surprisingly manageable in its complexity. “We generally try to express ideas as straightforwardly as possible and are only as exotic as necessary,” says Goetz. The result is a diverse mix of idiosyncratic sources of alpha.

“Carry” family and hit ratios

BlueBalance trades many forms of carry beyond classic currency or fixed income currency trades. A broad universe of risk factors lends itself to term structure trades and thereby extracts roll yield. “We are for example very active in the interest rate space, which provides so many different shapes of term structures that enable roll-down trades,” says Kahl. Most dislocations can be found in the forward starting space, capitalizing on curve-shapes as well as other implied parameters such as volatility and skew.

“There are many ways of defining carry: we see it very broadly as a positive cash-flow generated by the passage of time. By identifying such opportunities, we aim to increase our odds of capturing value even in a rangebound market and achieve high hit ratios,” explains Goetz. Hit ratios, measuring the percentage of profitable trades, have been between 50% and 75% and have been above 50% even on the hedges.

Ultra-diversified portfolio

The portfolio employs an unconstrained approach to markets and instruments, typically holding 60-90 trade ideas at any given time. Most transactions display low correlation to each other or their respective asset classes, with average pairwise correlations between trades hovering close to zero, regardless of whether daily or weekly data is used. Although correlations fluctuate over time, they are not actively micro-managed. “Position management isn’t driven by correlation shifts, which can be short-lived, as analysis indicates that this approach often only proves effective in hindsight,” explains Kahl. “The key is to deliver stability through a highly diverse portfolio.”

Hedging costs and benefits

The managers remain mindful of correlation shocks, even in a well-diversified portfolio. To counter left-tail risks, they integrate optionality and convexity to enhance portfolio resilience, resulting in a hedge book with positive skew. Consequently, the overall strategy’s return profile is fairly normally distributed.

The hedge book consistently holds defensive positions to stabilize the portfolio during volatile markets, achieving a level of capital efficiency that typically surpasses standard tail-risk strategies. This is made possible through effective transaction sourcing across diverse markets, which helps mitigate the typical “bleed” associated with hedging trades.

“We don’t operate with a fixed hedging budget, instead we take a holistic approach to portfolio construction and risk management,” explains Kahl. “For example, certain relative value trades have minimal hedging requirements, while other dislocations may require more direct exposure to specific risk factors. In such cases, we adjust by increasing hedges in other areas.” The hedges are tailored to the overall portfolio. “Hedges evolve over time, as each market crisis is unique,” adds Schülli. “We seek out attractive long-volatility exposure but aim to avoid purchasing it at extreme levels.”

Risk measures

At the top level, a multi-layered Value at Risk framework governs position limits and traded markets to avoid concentration and limit economic risks. While the strategy does not employ balance sheet leverage, swaps can still obtain substantial notional exposure especially in interest rates.

Each trade is subjected to rigorous risk modelling to estimate delta and other sensitivities, such as Vega and DV01. Additionally, capped risk structures are often employed to further control risk.

Recent trades

One of the top trades in 2023 wagered on Russell 2000 variance reconverging towards S&P 500 variance levels. This was based mainly on historical mean reversion and attractive pricing parameters, but had other attractive qualities. “Small cap exposure is usually more volatile, especially in times of stress, so it also has some mild hedging properties. We like it structurally and liked the trade because the two indices are in the same region and have the same holiday calendar so there is not much basis risk,” says Schülli.

Dividend derivatives have historically been a source of structural dislocation. “Normally growth assets like dividends should grow by 3-4% per year, but dividend futures often trade in an inverted term structure, decreasing over time. We were active in these curves for the last few years but have reduced our exposure as there is little value left,” says Schülli.

Opportunity set

Crisis years such as 2008, 2011, 2020 and 2022 often create dislocations and particularly attractive opportunities, though such disruptions are not essential: “Volatility generally works in our favour, as it creates more extreme movements across different factors. But we always manage to find some dislocations regardless”, says Kahl. “While we never see everything dislocated, there is always something to capitalize on.”

Liquidity and capacity

The longer investment horizon does not compromise on liquidity or valuation. “The portfolio and collateral are marked to market daily. A 10-year interest rate swap is a 10-year instrument but is still super liquid. A five-year trade is not intended to be held for five years – once the dislocation reverts, we unwind and move on,” says Schülli.

Nonetheless, capacity is conservatively estimated at EUR 2 billion. “We want to stay nimble and that is a decent size for transactions and liquidity so that we do not move prices. We want to maintain maximum diversification at higher levels of assets,” says Schülli.

Evolution

The portfolio has expanded from 30-40 to 60-90 trades over the years. “Our portfolio is already well-diversified, and we do not have a specific target for the number of trades,” explains Kahl. “The opportunity set continues to evolve, and we are constantly looking to add new markets, instruments and payoff structures.”

The selection of instruments traded can shift with market trends. “Fifteen years ago, we traded volatility bonds, which have essentially disappeared and been replaced by various forms of variance and volatility instruments. We adapt to market changes, new instruments and innovations, but remain committed to our philosophy of trading dislocations in market parameters,” says Goetz.

Counterparties

The fund currently collaborates with 11 tier-one banks. “This is crucial for generating more ideas, accessing a broader range of risk factors, risk transfer opportunities and securing competitive pricing,” explains Schülli. “Each bank has its strengths – some excel in interest rates, while others are stronger in equities. We leverage these strengths to build strong, long-term relationships.” Schülli is based in London to facilitate closer collaboration with the banks, while the rest of the team operates from Vienna.

Tech savvy team

AI is utilized for development, document processing and code documentation, but it is not employed for generating investment signals. BlueBalance seeks candidates with strong technical and mathematical backgrounds, as Vienna is a buzzing hub for talent with some of Europe’s most technical universities. “Programming skills are essential for quant roles, but we focus more on coding style and a problem-solving approach than specific language requirements. Candidates also need a real passion for financial markets,” says Kahl.

“We are running a holistically constructed and diversified single strategy with multiple return streams – in a way we are one single big pod,” jests Goetz, “So our compensation is based on team performance”.

A second fund

The second BlueBalance fund, a Luxembourg RAIF seeded by a Nordic pension fund, follows the same investment philosophy as the UCITS but targets higher volatility and returns. The two funds typically have around 80% position overlap, though the RAIF offers additional flexibility, including the ability to trade commodities and employ greater leverage. In 2022, the RAIF experienced a decline of 6%, compared to less than 1% for the UCITS. “The RAIF generally carries more exposure, particularly to fixed-income relative value trades, which were affected by the bond market sell-off,” explains Schülli.

However, 2023 proved to be an excellent year for the RAIF, with a performance of +14.5% and a Sharpe ratio exceeding 2.5, driven by a strong recovery in the rates book.

Differentiating alpha

Schülli sums up: “We are always earning carry, but not forecasting market direction. We are always true to our philosophy, but we evolve and adjust with the market. We strive to deliver a very differentiating source of alpha and be a real diversifier to our investors. We run one strategy in one niche and want to stick with what we are good at”.