Quest Partners‘s AlphaQuest Original is Up 16.2% In 2014. You can Read Quest Partners’s 2014 Year-end Letter Below.
In 2014, the AlphaQuest Original (AQO) program was up was up +16.2% vs. +12.3% for the BTOP50 CTA Index and +11.4% for the SP500. Since inception in 1999, AQO is up +571% vs. +109% for the BTOP50 and +54% for the SP500.
Market Commentary – When It Comes to Risk, Mind Your Own Business.
In 2014, global growth remained weak and economies required further artificial stimulation. Central banks continued printing money and repurchasing their own treasury bonds in an effort to lower long term interest rates and inflate asset prices. As one would expect, this had the effect of discouraging saving and encouraging borrowing and spending. These bond repurchase programs in the US, Europe and Asia targeted riskier and longer dated assets, pushing markets further away from natural equilibrium. Ten year Treasury bond yields dropped close to zero, leaving little room for further decline. Swiss ten year rates actually went negative in the beginning of 2015. It is worth mentioning that investing in 10 year sovereign bonds yielding close to zero might not be appropriate for some. This is particularly true as these yields are at or below stated inflation rates. From a purchasing power perspective, the losses on these bonds are almost certain. Relying on irrational behavioral biases, most investors still find these bonds safe and attractive. The positive effects of the current capital injections into the economy are small and declining. In the US, despite large budget deficits (-2.8% of GDP) GDP growth was still only (+2.7%) during the 12 month period ending 3Q14. A healthy looking increase in GDP is not so healthy if it is achieved through borrowing rather than through natural demand driven economic growth.
The decreasing effect of the current capital injections into the economy is also apparent from the steadily decreasing velocity of money since 1997. Effectively, the money injected in the economy is not circulating as it should to stimulate economic activity but rather forming asset bubbles in financial markets.
In addition to fixed income, equity markets were large beneficiaries of the loose monetary policies of the last decade. The SP500 is now up over +200% since its March 2009 bottom. The 3-year rolling Sharpe ratio of the SP500 is now at 2. This is highest it has been in the last 50+ years! Forward looking returns from these levels tend to be quite mediocre. In 1999, this ratio was also at +2 and in the following two years; the internet bubble popped sending the NASDAQ down -77%. In 2007, this ratio was just under +1.5 and in the ensuing two years, the SP500 lost over -50% of its value. The long term average 3-year rolling Sharpe ratio for the SP500 is 0.2 so we are at about 10x average value. As a side note, the 3-year rolling Sharpe ratio of the “All-Weather” 50% equity risk and 50% fixed income risk portfolio recently also reached an all-time high of +2.5.
The market capitalization to GDP ratio of the US equity markets is the highest it has been barring 1999. This indicator was described by Warren Buffett as “probably the best single measure of where valuations stand at any given moment.” This ratio also points to a substantially overvalued stock market.
From the point of view of historical ratios, equity and fixed income prices are generally indicating lofty valuations. Although this fact is known to most, investors are having difficulty staying away from exposure to markets. This is due to the fear of lost opportunity in investment income as central banks continue their dramatic actions. Inflation is a great threat to savings and larger than usual risk needs to be taken in order to maintain one’s purchasing power. Missing the moves in the real estate, fixed income or equity markets has been quite costly and investors are wary of missing similar moves in the future.
With markets stretched so far away from equilibrium, the potential for large moves is extremely high. Relying on fundamental indicators is also quite ludicrous due to the artificial equity, FX and commodity prices. While equity and fixed income prices are manipulated up, commodity prices are artificially kept in check through farming subsidies and tax breaks for exploration. Commodity prices are also kept in check by making access to commodity investments difficult through an increasingly prohibitive regulatory environment. In the last two years, the majority of large commercial banks had to shut down their commodity desks due to regulatory pressure. Countries with current account surpluses have to exert great pressure to keep their currency from appreciating.
All these efforts are doomed to fail sooner or later. The most damaging aspect of these price deforming actions is the guaranteed eventual runaway inflation once even a small fraction of these assets currently invested in financial assets start flowing into real assets such as commodities. Commodities, as they cannot be printed like stocks, bonds and FX, are much more difficult to control in the long term and typically lead the charge when inflation hits.
There are limits to central bank power. Prices and volatility cannot be controlled forever. This is very costly and requires steadily increasing pressure to achieve. Military might is a positive stabilizing force here but also has its limitations. Sooner or later, all central bank actions will have to be stopped and the prices of underlying markets will have to revert to their natural equilibrium.
A recent example of the price instability that can follow years of price manipulation happened on Jan 15th, 2015. On this day, the Swiss National Bank decided unexpectedly to let go of its cap on the Swiss Franc relative to the Euro. Within minutes, the Swiss Franc had moved 52 daily standard deviations against the dollar and 189 daily standard deviations against the Euro, its previous peg. Typical risk models assume 2 or 3 standard deviations as being a fair assessment of maximum risk. The damage was quite substantial for those found on the wrong side of the trade and hiding in the safety of this carry trade. Here is a graph that shows the placement of the EURCHF and USDCHF moves in relation to their probability distribution.
Such is the force released when markets are allowed to move freely after years of interventions. With such moves pent up in most markets, we do not see fundamental value providing protection or a margin of safety when investing today. Effectively, we see fundamentals as being less and less relevant in today’s macro markets. In contrast, technically based, short term (less than 10 days per trade), positively skewed approaches can still provide protection should such moves materialize. The most positive skew is achieved with models between seven and ten days per trade. An important distinction to make is that we estimate that more than 80% of assets invested today in momentum and trend strategies rely on longer term models which do not have intraday stops in the market and average over 30 days per trade.
These slower trend models, typically long bonds, have relied heavily on the negative correlation between stocks and bonds of the last 15 years to provide risk protection during equity drawdowns or market shocks. Although this correlation has been around -30% in the last decade, its historical average is closer to +20%. Mathematical correlation does not imply causation. Should this relationship break, equity and fixed income investments as well as the “All Weather” portfolio would be dramatically impacted. AQO, due to its reliance on short term models, is more likely to capture sharp trend reversals and to better withstand a change in correlation between stocks and bonds. In fact, we would expect that AQO would be a great performer in such an environment.
As of the first quarter of 2015, some of these pent up instabilities are starting to materialize in markets. In addition to the 20%+ overnight Swiss Franc move, Crude Oil dropped over 55% without any previously known fundamental justification. Similarly, Copper dropped 30% without any visible fundamental change in the supply/demand picture. It is possible that these two economic demand driven commodities are signaling a slowdown in the global economy. With long term interest rates near zero, central banks have less tools available to influence economic and market activity.
With volatility levels in equities, fixed income and FX in the bottom decile of their range, we see plenty of opportunity for increased volatility ahead. Starting from similar volatility levels in mid-2005, there was a +150% absolute return run-up in AQO returns which lasted four years. It is possible that volatility materializes whether central banks have to let go of some market caps or not.
The ability for humans to balance short-term and long-term gain is the subject of much interest and research. This ability to delay gratification has been linked to numerous positive outcomes in life including academic and financial success, physical and psychological health and social competence. This ability is highly linked to will-power. Human will-power, which evolved over many millennia, can correctly balance short-term and long-gain and delay gratification in normal circumstance but it does have weaknesses. One shortfall is that it can be weakened by repetition: it might be easy to resist a vice once but if repeatedly tempted by it over a period of time; typical will power is more likely to succumb to the vice. Another shortfall is super-normal stimuli; typical will power can resist normal stimuli but it much more likely to fail to super-normal stimuli.
Today’s equity and fixed income markets test the human will from two perspectives. The first through repetition: with their slow ascent which over a long period of time repeatedly tempts investors to take more equity risk and second through super-normal stimuli; due to Sharpe ratios higher than ever, they test the human will which has never experienced such friendliness and sugar-coating.
Slowly since 2009, investors have been lured into risky markets through extreme level of central bank support, low volatility and addictive sugar-coating of otherwise sometime bitter markets. This support has simplified and eased the fear and emotional difficulties that typically come with naked long equity market exposure. The two pillars of discipline and conscientiousness necessary for long term investment success have now been abandoned in exchange for the two vices of greed and the fear of missing the obvious low volatility trends in equity and fixed income. Investor conviction in current markets has not been tested for years.
The premium between current asset prices and their fair value, uninfluenced by central banks, is at levels unseen in our lifetime. This dichotomy in signals leads to extreme levels of stress and confusion. To ease this pressure to perform under substantial risk, investors seem to be doing the most dangerous thing of all: finding comfort in being part of the investment crowd. This deeply engrained behavioral habit, highly successful as a survival mechanism in the wild, is a sure way to fail in the investment world.
Empirical evidence shows that momentum strategies have performed as well as, if not better than, value strategies both on a returns and risk-adjusted return basis over many decades. Nonetheless, investors continue to allocate the majority of their assets to fundamental value based strategies and indexes. The cost of this mistake is undeniable both from a return and risk perspective. In the coming high volatility market regime, major re-pricings of artificially buoyed markets will be common. Investors who act with self-awareness and independence from the crowd and its behavioral biases will have substantially higher chance of success. Momentum strategies with the least exposure to the common investment biases of the day should be able to provide a safe refuge and substantial return for these investors. In particular, should some of the potential highlighted scenarios manifest, we would expect AQO to provide substantial returns and perform as an excellent hedge, as it has in the past.
When it comes to investment risk, mind your own business!
AlphaQuest Original (AQO)
Quest’s flagship strategy is a diversified, multi-time frame, systematic futures and FX trading program that seeks to deliver positive Alpha with positive skew. Trading time frames range from between a few hours to over 3 months with average trade length of 7 days. Over its 15 year history, AQO has delivered +11% of annual Alpha to the SP500 and +7% annual Alpha to the BTOP50 Index.
AQO returned +16.2% for the year as compared to +12.3% for the BTOP50 Index and +11.4% for the SP500. Sector performance was driven primarily by gains in fixed income (+9.8%) and energies (+9.1%).
Performance in fixed income was noteworthy as global yields saw large declines. The rate declines occurred even as the US Federal Reserve officially announced the end of quantitative easing. However, during the year other developed country central banks initiated their own versions of QE, most notably the ECB, BOJ and PBOC.
The ECB’s move towards full QE, due to increasing deflationary signals in the Eurozone, provided strong trends that proved well suited for AQO’s models. In 2014, AQO returned +9.2% on a gross basis in German Bunds making it the best performing individual market.
The energy sector’s gains can be attributed to the sharp declines during the second half of the year in crude oil (+3.3%) and brent (+1.7%) due to the weakness in the EU and China and growing production in the US.
The intermediate and long term trend following models provided the bulk of AQO’s gains as they returned +11.0% and +8.9% respectively. These returns result from the significant trends in global fixed income and energy markets.
Short term models experienced most difficulty as implied volatilities in the FX sector dropped to their lowest levels of the last 50 years in 1Q14.
AQO remains positioned to outperform in periods of high volatility and high volatility of volatility. In 2014, although trends started to manifest, the overall volatility environment remained extremely low as can be illustrated in the graph below. We have refrained from making investment biases which improve performance in low volatility periods at the cost of performance in high volatility periods. Please refer to our research pieces for more details on this topic.
We are extremely optimistic of the return potential of AQO in the coming years starting from such low volatility levels. AQO remains an exceptional stand-alone investment as well as a great addition to equity or hedge fund portfolios.
Quest Equity Hedge (QEH)
QEH is a quantitative risk-off program targeting -0.9 Beta to the SP500 with positive Alpha and positive skew. QEH is designed to hedge equity exposure, hedge fund portfolios and tail risk. QEH shares the trading methodology and sources of Alpha with the AQO program with an additional condition that it focuses on positions that provide negative Beta to the SP500.
QEH returned -0.4% for the year compared to -13.0% returns for the Short S&P500 Index (SPXTS). QEH’s outperformance can be attributed to gains in fixed income (+8.5%) and energies (+7.2%). Losses in equities (-5.8%) and FX (-10.6%) offset some of those gains.
Since inception 20 months ago, QEH has outperformed its short SP500 benchmark by about +18%. This is particularly significant as QEH was able to achieve these returns despite strong negative correlation to equities which were making new all-time highs throughout the year. We expect QEH returns to be quite strong should equity markets actually experience a correction. The Beta of QEH positions to the SP500 is bound between -30% and -180%. In comparison, classical momentum strategy positions can have Betas to the SP500 as high as +200%.
QEH provides substantial benefits versus hedging strategies which rely on market timing stock indexes short/flat. QEH is able to generate negative Beta to equities with positive returns despite strong equity market periods globally. We believe that the outperformance trend vs. the short SP500 benchmark will continue over the years to come and will actually increase during stock market corrections.
It is important to note that, by relying on long fixed income positions, even traditional equity/fixed income portfolios, “All-Weather” portfolios and long term trend following strategies have been able to historically generate some negative Beta to the SP500 with positive returns. In comparison, QEH’s negative Beta to the SP500 can come from any position (long or short) in any sector (equity, fixed income, FX and Commodities) and is therefore much more stable over time. We expect QEH to continue to provide negative Beta to the SP500 with positive returns even as the correlation between fixed income and equities shifts to positive. In the future, one might have to be short fixed income to generate negative Beta to the SP500. This is not a natural position for the traditional equity/fixed income portfolio, the “All-Weather” portfolio or long term momentum strategies.
Due to its strong negative correlation to equities, QEH is able to reduce the volatility of equity portfolios up to 50% even as equities are experiencing strong uptrends. In comparison, momentum strategies are able to reduce the drawdowns, not the volatility, of an equity portfolio during prolonged down periods but not during sharp reversals or when equities are making new market highs.
We believe that once QEH is better understood, its trading principles will become the new standard for hedging in macro markets.
Quest Fixed Income Hedge (QFIT)
QFIT is designed to hedge fixed income downturns using a similar trade filtering methodology as QEH in relation to the US 10Y bond contract. QFIT only enters positions that provide negative Beta to the US10Y.
QFIT returned +0.6% for the year compared to a -8.0% loss for the short US 10Y Bond Index. The outperformance can mainly be attributed to gains in FX (+3.8%) as the program profited on the rapid depreciation of the euro and the yen.
Since inception 14 months ago, QFIT has outperformed a short 10Y Bond position by over +8%.
With bond yields near historical low, QFIT is a very relevant hedge mechanism for fixed income risk.
Quest Tracker Index (QTI)
QTI is a low cost transparent systematic program that seeks to replicate the performance generated by the broad class of trend-following CTAs, and to match the performance of widely-followed CTA indices on a risk-adjusted basis. QTI is comprised of 47 specified futures contracts in markets for commodities, currencies, equity indices and fixed income. QTI’s index level is calculated daily by S&P Dow Jones Indices and published on Bloomberg (QTI ).
Continuing to exceed expectations, the QTI program returned +21.7% for the year vs. the Newedge CTA Index (+15.7%) and the Newedge CTA Trend Sub-Index (+19.7%). The correlation of QTI to the Newedge CTA indices remains high at +80% in live trading. Since inception just over three years ago, QTI accounts have outperformed CTA indices and large CTAs by about +4% per annum or +16% in total.
We are pleased to announce that on December 19th, QTI was shortlisted for the 2015 CTA Intelligence US Performance Awards in the category of “Best Investable CTA Index”. Winners will be announced February 5th.
Quest CTA Research Series
During the second half of the year, Quest published three new research papers. In each of these papers, we highlight specific risks that both hedge fund and CTA investors may not be fully accounting for.
Our fourth research piece in the series, Mean Reversion: Illustration of Irregular Returns in US Equity and Fixed Income Markets, illustrates the presence of extreme levels of mean reversion in the SP500 and US30Y bond markets. The paper highlights the dangers that investors face when they attempt to use linear risk models to differentiate between skill-based Alpha and unstable, tail risk-based Alpha. Our paper argues that a lack of differentiation between these sources of Alpha is a major source of risk that will lead to otherwise avoidable losses during the next equity crisis
In our fifth research piece, Hedge Fund Index Replication: A Numerical Approach using Futures, we describe hedge fund index replication using liquid futures contracts. The numerical replication of the Credit Suisse Hedge Fund Index (“HFI”) that we propose in the paper shows that superior security selection has little or no impact on HFI’s Alpha to the SP500. Our replication efforts also reveals that stale pricing and return smoothing in hedge fund indices are sources of hidden market risk and is being erroneously assigned as sources of Alpha.
The sixth research piece, Return Enhancing Style Drifts in Futures/FX-Based Momentum Portfolios, discusses how the CTA industry has adapted to benefit from recent central bank driven anomalies in futures and foreign exchange markets. Chasing liquidity and recent returns, large CTAs in particular, have ended up being cornered into some very specific factors which happen to have performed well in the last five to ten years. However, the six specific style drifts that we highlight caused substantial underperformance versus a classical trend following strategy during the ‘07-‘09 crisis and do not involve true skill-based Alpha.
In June, Quest introduced a new family of short term models branded “Trend Crowding” to the AlphaQuest Original program and related strategies. These new models attempt to profit from
overcrowding in the CTA space by exploiting market inefficiencies created by large trend following market participants. In recent years, markets have been more likely to be attracted to trend reversal points than to reverse shortly thereafter. Trend Crowding uses these high pressure points as a potential entry points for short term trades. Adhering to Quest’s philosophy, the Trend Crowding models are applied similarly across all sectors and markets.
Individual Equity Trading
After a short but concentrated research effort, we are excited to start trading an individual stock and ETF portfolio on proprietary capital. The program will be purely technical in nature at the start. The long side of the portfolio will be comprised of a mix of momentum and short term mean reversion strategies including models exploiting inefficiencies around earnings announcement dates. The short side of the portfolio will be comprised of short term mean reversion trades and a version of our QEH program adapted to be traded using ETFs. We expect the overall equity portfolio to be slightly net short the market over time but with substantial Alpha.
Trading and Technology
Quest implemented a number of key improvements to its trading infrastructure in 2014. In an effort to provide more robust broker communications, Quest implemented FIX order routing capabilities with its major execution counter-parties. This new platform also provides the backbone for future execution and order routing upgrades. These changes towards a more automated trade execution methodology have been continuous over the years.
In addition, Quest has completed its migration to a new disaster recovery site hosted by InfoHedge Technologies, the first and the largest private cloud provider in the investment management space. The new backup site was successfully tested in August. It provides a fully redundant trading environment that can grow as Quest’s technology needs evolve.
In July, Quest welcomed back its former Head Trader, Robert Toth. From 2010 to 2014, Robert was Head of Trading at Vegasoul Capital Management, where he was responsible for global trading, technology, and quantitative research, with a specific focus on transaction cost analysis and portfolio optimization. Robert first worked at Quest from 2005 to 2010, when his responsibilities included quantitative development and trading.
In June, Quest was pleased to welcome Darren Johnston to the position of Chief Operating Officer. Darren brings over 13 years of alternative investment management experience to the role. From 2005 to 2013, he was Director of the single manager business at leading fund-of-hedge-funds advisor, Tremont Group Holdings, Inc. From 2001 to 2005, he was the Chief Operating Officer and Designated Compliance Officer of Tremont’s Toronto-based subsidiary responsible for the execution of Tremont’s Canadian business plan. In September, Darren took on the additional role of Compliance Officer.
Over the past few years, Quest invested heavily in its infrastructure, operations and technology. It has serviced and continues to service some of the largest and most demanding pension plans and clients in the world. With its research, it has been able to continuously educate, stay ahead of the competition and provide Alpha which is based on true skill rather than on short tail risk exposure. This Alpha has been highly beneficial to equity and hedge fund portfolios.
Now, after half a decade of extremely low volatility, global markets are primed for substantial moves and increases in volatility. Due to its short term, positively skewed trading style, Quest is very well positioned to participate and benefit from these market moves.
As more and more investors realize how outstretched and monothematic markets have become, a tipping point in market regime is bound to happen. As markets typically have strong memory, we believe that the volatility to come will be a mirror image of the stability of the past few years.
We look forward to continuing our growth as we serve the investment community.
Thank you for your support.
Founder and CIO
Quest Partners LLC
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