London-based Quality Capital Management has a hybrid-trading strategy that can follow trends but also avoids the sharp reversals that often accompany them. Aref Karim, QCM managing director and CEO, says that the underlying algorithm behind his three programs keep them in, and sometimes out, of most long-term trends. “Our strategies are opportunistic, they go wherever the action is,” Karim says. That is because his Advanced Resource Allocator (ARA) algorithm adjusts position sizes on the fly.
“We are not a traditional trend follower. The dynamic asset allocation of our program can get you in and out of long-term trends. We could have a very long term perspective to initiate a position, but it doesn’t mean we are sticking with that position all the way through. We could be periodically out of the position,” Karim says.
The system is long term but it constantly rates the strength of each position and adjusts the sizing. When it works best, that means it will catch the big trends, lighten up during corrections and build back the position as the trend resumes without having to produce another entry signal. “There is considerable borrowing and lending going on in the risk budget allocated to the portfolio so that you pull resources from positions that look relatively unattractive and lend to those that look more attractive,” Karim says.
“The objective is to get large positive returns, it is the skew that we are after. Our strategies are not shy of upside returns. In focusing on upside volatility, we therefore have to borrow away from those opportunities that are less attractive and lend to those that are more rewarding,” he adds.
QCM’s system has a long-term momentum component and a short-term tactical component; like the allocations, the ARA determines the weightings of these two models. “ARA looks at relative strength, asking which is likely to perform better. Is it the momentum model or is it the short-term model? And it will increase the weight in one versus the other depending on what the outlook is,” Karim says.
In 2006 that has worked tremendously well in all of QCM’s programs. The global diversified program, which trades 80 global futures markets, returned 35.11%; the global natural resources program, which trades 36 physical commodity markets, returned 35.74% and the enhanced commodity beta program, which trades the same 36 commodity markets from a long-only perspective, returned 50.24%. The beta program mixes the benefits of long-commodity exposure with the ARA algorithm to combine the best aspects of active and passive management. “It is a bit of a hybrid. If you look at last year, the Goldman Sachs Commodity Index was down 15.09% but we were actually up 50%,” Karim says. The beta program combines elements of absolute return strategies with beta elements due to its long term, long-only approach.
For example, QCM has had a long-term position in copper that was reduced by ARA in May, avoiding a significant correction, and then added back as the trend resumed.
“Prior to the sell-off, we started to lighten up our positions, which is why we didn’t suffer too much. The metals markets became very volatile and the ARA was saying the probability of us making additional money in those markets were diminishing, so therefore the resources were being lent out to other opportunities.”
Perhaps the best example of the benefits of Karim’s ARA method occurred in the volatile markets following Hurricane Katrina in 2005.
“Our system halved the weight very quickly in equities and ramped up the weight into energies, so we took full advantage of the energy run-up and we lost very little in the equity sector because we hedged out very quickly,” Karim says. The ARA put back many of those original weights by the time the two sectors reversed in September, making money in both months. “This shows the dynamic nature of our system and how opportunistic it is.”
To demonstrate how powerful the ARA is, he points out that his beta program has vastly outperformed the commodity indexes, returning 50% to the GSCI’s -15.09% performance and the Rogers International Commodity Indexes’ 8% year. “The answer is in the way we do our active asset allocation which is determined by the ARA,” Karim says.
Karim’s models worked particularly well in 2006, a year that saw both sustained moves and sharp corrections in the energy and metals sectors. “The system is conscious of subtle changes in market conditions and it adjusts very quickly. The speed at which things happen is important to us. If the market shows signs of a likely top from a probability standpoint, the ARA is very quick to look at what else is out there.”