Quality Capital Management

BILL McINTOSH

The choice available to investors looking to allocate to commodity trading advisors has come a long way since Aref Karim set up Quality Capital Management in the mid-1990s. Now QCM is poised to ride the growing tide of institutional investors that consider CTAs a smart bet during a time of substantial market upheaval.

The growth of CTAs into one of the top strategies by assets under management has coincided with Europe replacing the US as the home of the biggest managers with firms such as AHL, Transtrend and Winton Capital. Though QCM’s track record isn’t out of place in this illustrious group, it is a more nimble player given assets under management of $900 million. But unlike the founders of many CTAs, Karim, while fairly fluent in financial maths, isn’t an out and out quant.

“I don’t think you need to be a quant,” he says in an interview at QCM’s campus-style headquarters in Weybridge, Surrey. “I believe investing is an art and a science. Otherwise every rocket scientist would be a big successful hedge fund manager, but of course you have seen a number of them fail. What is required is creativity, perseverance and a sense of discipline.”

Investing experience
With Karim, that discipline is informed by some earlier academic knowledge of physics, chemistry and mathematics as well as a chartered accountancy qualification. He is also an experienced hedge fund investor: prior to launching QCM, Karim spent over 13 years investing in alternatives for the Abu Dhabi Investment Authority. His experience thus covers a wide range of strategies and models.

“I look at the bigger concepts rather than try to get into the micro elements,” says Karim. “I would not call the strategies we run parametric (i.e., making inferences about the parameter of a distribution). There aren’t lots of models or moving parts in our strategy. This is common sense stuff but applied with a lot of discipline and consistency. That is what systematic strategies are about.”

QCM’s key aim is to avoid tweaking strategies to accommodate signals generated by market price mechanisms. Changing or fitting strategies with increasing frequency means that systems decay rapidly, requiring that parameters change in step with changing markets.

“If you have to change, adapt and recalibrate on a regular basis to me that is a sign of concern,” says Karim. “We really focus on robustness. That comes from having not too many inputs in the model. There is a fine balance. We want good change if I can put it that way, but we don’t want frequent change just for the sake of it. We are extremely meticulous in employing and incorporating enhancements into the model.”

The first factor to test is whether a solution is general (to a number of asset classes) or more specific to just one. If, say, coffee and US government bonds can be profitably traded in a similar fashion in the same time window then the system would, inter alia, be deemed more robust than one that says coffee is different from bonds and so requires the use of a different parameter or approach. Though individual asset markets may have unique characteristics, an approach that can factor it in without modifying the variables, should be more robust. It should also avoid risks from arbitrary time selections in historical observations.

QCM1

Following the flow
As markets and technology have changed, QCM’s approach to investing has continued to evolve with time. A central point of difference with QCM is its use of a flow-based approach set-up during 2003-05. In a background note this is described as ‘a unique systematic macro strategy that drives the process with fundamental and economic rationale placing large-scale emphasis on dynamic asset/risk allocation rather than indicators.’

“If you look at the CTA world it is dominated by trend followers,” says Karim. “Why? Because all you need is to come up with a trend indicator that says ‘Get on board, there is evidence of momentum in this direction.’ You just want to ride it until it either reverses or at some earlier point you take some profits. The issue is that it is a very linear approach. The signals are predominantly generated by price. That to us is a bit light-weight. We did in the past run like this. But strategies evolve.”

Rather than depending on a series of price-based indicators, QCM uses an allocation model that looks for short-term changes in acceleration. In 2008, forexample, the Lehman collapse suddenly triggered huge fear in financial markets, bringing about deleveraging and rates going to zero.

“There was a huge flow of money from risk assets into non-risk,” says Karim. “Effectively that meant a flight to quality assets – treasuries, the dollar, gold. These became the assets to be invested in.” Moving with those flows meant that QCM had shifted over 70% of its allocation from risk to non-risk assets including interest rate futures and dollar yield curve crosses by the end of 2008.

QCM GDP Fund Table
Click for larger image

A continuous flow
“Some would have achieved the shift in exposure by moving in steps, using price triggers to reduce or exit from risk assets, and then initiating and building on shorts. A large part of their returns may have been generated from those shorts”, says Karim, “whereas we changed exposure in a more continuous basis through flows and into long positions in non-risk assets.”

The system calibrates risk and liquidity premiums. During times of fear it steers flows to take the liquidity premium offered by, for example, Treasuries. At other times it veers toward risk premia because returns are superior. Consequently, equities and commodities, being the chief risk assets, will always be in the forefront of the programme’s exposure. Though risk caps are put on particular positions, commodities or equities per se won’t be capped at a particular level, if the model continues to see a higher risk premium available.

By simple offsetting between short, medium and long-term price signals, risk management may be served but with the added impact of diluting performance. Risk management is well covered, but return management isn’t.

Avoiding opportunity cost
“In other words, there is an opportunity cost,” says Karim. “This is where we are more conscious. When we talk of asymmetrical returns what we are very conscious of is the skew or the upside potential. We want an option-like profile. In order to achieve that we believe in not having a lot of moving parts with price-based indicators. The problem becomes one of choosing the right parts and needing to constantly recalibrate. We felt the way to correct that was to almost discard the dependency on these indicators and go for something bigger,” he says.

The implication is that data about different asset classes, such as coffee and bonds, is analysed in the same way. In other words, the primacy of the signal is absolute. “It doesn’t matter whether the time signal is for commodities or financials or currencies,” says Karim. “A strategy which can make money and is totally indifferent to the behaviour construct has to be a lot more robust.”

With fewer variables system decay and degradation of returns is less pronounced. In addition, style drift and the associated risk are correspondingly curtailed. And the fact that the programme is flow-based means that it is very scaleable in terms of capacity and carries some economic intuition.

Fund offering
The firm offers three funds: the flagship QCM Global Diversified Programme; the QCM Global Natural Resources Programme and the QCM Enhanced Commodity Beta Programme. Each fund is offshore and each offers managed accounts for larger investments. Global Diversified is also available in a UCITS wrapper through the db Platinum platform.

Enhanced Commodity Beta is long only and seeks to outperform commodity index benchmarks such as Goldman Sachs Commodity Index and DJ UBS Index. It is an actively managed product with a tested allocation model. Global Natural Resources is a specific offering for allocations from investors with an absolute return focus in commodities. All funds trade one or both of two asset classes expressed in futures: paper, meaning financial assets, or tangibles, meaning commodities.

The return features of Global Diversified and CTAs generally, including tail risk protection and minimal correlation with equities, have helped them gain favour with institutional investors looking for investments bearing those characteristics. What’s more, the long-term track record shows there is alpha to be acquired at other times. But since CTA’s strong performance in 2008-09, some managers have remained in drawdown, though recent gains are putting most near new high water marks.

CTA drawdowns
Karim voices scepticism about the accepted view of what constitutes a drawdown. After Global Diversified chalked up a near 60% return in 2008, it lost 12% in 2009. “It was just a calendar function that the peak came at the end of the year when we rolled over a large part of unrealised gains,” he says. “When you have moves of that magnitude it takes time to readjust. Volatility shrunk in 2009 and the adjustments in the models were pretty large to realign to a shrinking volatility paradigm. That is what cost us. This was a lag effect that took place over a period of time.”

In the sequencing of events, a drawdown may well be a factor of outlier events. Sequencing of negative months leading to a drawdown is difficult to forecast. As a result, paying too much attention to these events in constructing the model can degrade its potential and give up long run returns.

“I look at managed futures as a classic options strategy – a long volatility strategy,” Karim says. “You may pay a premium periodically, but you recover this and it becomes a zero cost option over time. And as with any option it can go ‘out of the money’ at certain times, but with a robust strategy, the option eventually kicks back in. Why? Because most CTAs realign themselves with market direction: the models tend to be self-correcting. In the end it is usually the lag in adjustment of positions that cost you.”

Japan office
QCM’s progress toward the $1 billion AUM milestone coincides with the opening of a Tokyo office in June. It is being run by Osamu Nishimura, an ex-Itochu executive, who is a veteran in derivatives trading, hedge fund investment and funds marketing.

For a CTA, Japan is an ideal market. It has a massive savings rate and financial services companies with massive capital pools. These factors are coupled with zero interest rates, so making investors hungry for returns. In this regard, it is instructive that a Man Group-Nomura venture has raised $2 billion for a managed futures vehicle. With a toehold there, it also means that QCM can cover South-East Asia and even Australia from Tokyo.

A historical perspective

While with ADIA, from 1982 until 1995, Karim was with the sovereign wealth fund’s Alternative Investment Department, looking after policy, strategy and allocation for a multi-billion dollar portfolio. During that time and the 16 years of running QCM, Karim has witnessed major alterations in the alternatives landscape, not least in the perceptions of investors.

“One of the biggest things to change is removal of the scepticism about hedge funds,” he says.

“Back in the 1980s hedge funds were described as secretive clubs that didn’t disclose what they did. That prevented institutional investors from coming into the strategies. Over the years the veil has been lifted. With greater levels of disclosure and increased regulation we’ve seen increasingly more mainstream investors allocate to hedge funds.”

The background with ADIA gave Karim a choice not normally open to managers planning to set up a new firm. Since he had been a hedge fund investor, Karim did initially consider setting up a fund of funds. But the attractions of being an independent portfolio manager proved decisive in setting up QCM.

On the matter of choosing a quant or a discretionary approach to investment management Karim really had only one option. His experience in selecting and monitoring managers at ADIA had provided ample proof that style drift was a very real risk. What’s more, he had observed that even a long track record could be meaningless when a manager changed his trading style.

“The track records of systematic funds, in my mind, are a lot more reliable,” Karim says. “When people talk about risk philosophy for me one of the biggest risks is style drift because it is a silent killer. With discretionary managers there is a tendency for larger style drift. Investors look at a track record and assume that the pattern will continue in the future. But the trading style may have changed considerably, due to factors that are personal to the manager. From an investor perspective the lack of application of a strategy with consistency is a serious risk.” Systematic managers are not totally immune from such risks either, but there is a greater chance of some consistency in decision making with model-based approaches. In the end it is a choice of philosophy.

With a systematic futures approach, it is clear that Karim and other CTAs have developed investment models of enduring value to investors. The flight to cash and CTAs in the current investment climate demonstrates this clearly.

“If you have created something that combines ‘flight to quality’ characteristics with CTA returns then there is something that will likely be valuable across all different environments,” he says. “That is a far more robust way to trade the markets.”