The Derivative - The NON-Wisdom of Crowds with Nigol Koulajian of Quest Partners

Episode Date: May 6, 2021

In through the nose – out through the mouth. In through the nose – out through the mouth. You’ve now joined a headspace where we think you’re prepped to focus in and become one with today’s guest. He’s a well known CTA, expert researcher, meditation and yoga practitioner, and Founder & CIO of $1.8 Billion in AUM = Quest Partners. Today’s guest is none other than Nigol Koulajian, he’s been in the business since the early 1990’s and has grown to become one of the leading voices in alternative investments. Today, we’re talking with Nigol about Covid New York, Nigol’s quest to becoming a CTA, what it’s like managing more than a Billion dollars of people’s hard earned money, assessing price & risk in a portfolio, gaming Sharpe ratios, applying meditation to Quest’s quests, how easy it is to replicate hedge fund and CTA performance, Nigol’s favorite whitepapers, gaining convexity relative to skew, 30,000 ft view of Quest’s programs, “playing the players, not the game,” prioritizing meditation and mindset, and The Quest Indicator Book. Chapters: 00:00-02:03=Intro 02:04-16:51=The Quest to Becoming a CTA 16:52-28:22=Meditation Mindset: Priming the Mind 28:23-51:42=The Power of Positive Skew Models 51:43-01:07:07=Gaming the Sharpe & Playing the Players 01:07:08-01:28:20=The Quest Book 01:28:21-01:31:47=Favorites Follow along with Quest on LinkedIn and on their website, and keep up to date with Nigol here. From the episode: Access Quest’s whitepapers and research here Sign up for monthly access to the Quest Book here Don't forget to subscribe to The Derivative, and follow us on Twitter at @rcmAlts, and our host Jeff at @AttainCap2, or LinkedIn, and Facebook, and sign-up for our blog digest. And visit our sponsor, the CME Group at www.cmegroup.com to learn more about futures and options. Disclaimer: This podcast is provided for informational purposes only and should not be relied upon as legal, business, or tax advice. All opinions expressed by podcast participants are solely their own opinions and do not necessarily reflect the opinions of RCM Alternatives, their affiliates, or companies featured. Due to industry regulations, participants on this podcast are instructed not to make specific trade recommendations, nor reference past or potential profits. And listeners are reminded that managed futures, commodity trading, and other alternative investments are complex and carry a risk of substantial losses. As such, they are not suitable for all investors. For more information, visit www.rcmalternatives.com/disclaimer

Thanks for listening to The Derivative. This podcast is provided for informational purposes only and should not be relied upon as legal, business, investment, or tax advice. All opinions expressed by podcast participants are solely their own opinions and do not necessarily reflect the opinions of RCM Alternatives, their affiliates, or companies featured. Due to industry regulations, participants on this podcast are instructed not to make specific trade recommendations nor reference past or potential profits, and listeners are reminded that managed futures, commodity trading, and other alternative investments are complex and carry a risk

of substantial losses. As such, they are not suitable for all investors. Welcome to The Derivative by RCM Alternatives, where we dive into what makes alternative investments go, analyze the strategies of unique hedge fund managers, and chat with interesting guests from across the investment world. Most hedge funds generate alpha by exposing themselves to tail risk. So effectively, the more tail risk you expose yourself to, the more alpha you have, the higher your Sharpe ratio. And in the context of a bull market, that's not a problem. But when you take the whole equity market cycle into account, you see that you pay very, very dearly for that negative skew once every three years, five years, 10 years, once central banks are less active in the market.

So we took the approach that effectively, because of what central banks are doing, volatility is very cheap and people are selling it almost at any price in order to achieve an alpha, which investors then perceive to be skill-based. So basically, we thought that approach seemed to be working very well. I don't think it's a long-term stable approach. Hello everybody, welcome back. I'm excited to have the founder and CIO of one of my favorite managed futures firms with us today. We've got Nigel Kalajian joining us, founder and CIO of Quest Partners, which is the $1 billion plus systematic trading shop that's been posting returns since 1999 or so and seemingly playing chess while the rest of us played checkers the past 20 years. So welcome, Nigel. Thanks, Jeff. Good to see you. How'd I do on the last name? It's okay? I'm learning at the same time as you.

And where are you? You're in Manhattan? Yep, currently in Manhattan. Survived COVID in Manhattan, so not so bad. Yeah, Upper East Side. What's it been like? Has it been tough this whole COVID time, or it's been... Not at all, I have to say. I haven't kind of like plugged into the mass media frenzy around it so

it's been relatively pleasant and quieter than usual I have to say quite pleasant right you think the rumors New York's dead and it won't come back or will it bounce back eventually let's say New York feels like it's coming back because traffic is back especially last, and I think they're

opening the restaurants even more in the next couple of weeks. There's a serious supply of office space. Obviously, most people are not coming back to the office very soon, and that's going to take some time to handle that. But otherwise,

the everyday action is back but I'll say the real estate market and the people coming back to the office is gonna take some while technology has won on this one and yeah I hear you and then people just convert that all to residential but is that even right can you have that many residential units uh you know it's a balance that's it's happened in the past people have moved out of the cities and come back depending on you know manufacturing and by the different cycles of the economy uh on this one i'm gonna say technology has won and it's a it's a big win uh i think it's gonna be hard to convince people to come back uh in a crowded city uh uh real estate at a hundred dollars per square foot plus per year and that

type of thing. It's gonna take a while. How about you guys on a firm level? Do you have plans to leave the city or you'll just get a little cheaper spot? I don't think so. I mean we're always considering all options but I would say nothing apparent right now. I mean, I spend a lot of time upstate New York in Woodstock. I like being in nature and getting away from the mindset of the city. But as a firm, I think we'll maintain, you know, obviously the headquarters here. And, you know, some

people are, you know, people are taking chances and getting further away from the office. But that's fine. That's fine for us. Everything's functioning totally fine. Love it. So give us a little background where'd you grow up how'd you get into this hedge fund space and being a quant and all that good stuff um i grew up in beirut lebanon believe it or not uh uh obviously war zone when i was growing up it was quite uh quite a scary place i was born of Armenian parents, basically Armenian descent, so somehow in my background there's kind of the collapse of the Ottoman Empire and all that

was like always there. I came to New York initially to finish high school but went to college instead completely by chance. notre dame electrical engineering then i worked for anderson consulting for four years colombia business school and then out of business school i was ready to start a cta basically in 1994 couldn't get the capital to start the cta so i did a couple of side jobs like trading for a risk arb fund and also running a fund of fund for a couple of years and then finally in 99 i had enough interest to start the cta and i did so electrical engineer that's interesting right a lot of these i feel a lot of quants that before there were

quant programs were kind of engineers or the engineering mindset for sure um and notre dame i didn't know that did you know Salem Abraham not I think it was there at the same time as me yeah and then you both kind of said hey we're gonna go be a CTA it's interesting and then how do you go from just business school to I want to be a CTA something piqued your interest there well I saw that there were so many smart people around and I had to find a niche where I could compete. Something which was technical enough and required very focused thoughts in a certain way, but at the same time, not very necessarily, not very plugged into the world as much.

Kind of like a very specialist type of thinking. I thought that worked well for me. So I decided to focus i focus on it and basically uh i taught myself how to be a cta etc etc uh were you having mentors or anything like that but were you reading books or like how did you first feel like say oh these futures markets look interesting versus like i should start to pick companies or pick stocks or things like that I mean I used to read investors business daily and that was very entertaining because they give you all these tools to pick stocks and to evaluate the strength of the stock market and

all that so at the time this is I'm talking 1991 I'm 24 years old and I bought trade station and started testing a lot of these indicators that Investors Business Daily was publishing and effectively nothing really stuck. I was like, my God, all this data, all these things and everybody's following all these indicators, but really it seems like nobody's actually

tested these things because they don't seem to provide value beyond the basic momentum effectively. So that didn't work. And then the benefit I saw in futures was the liquidity. You could actually trade very short term with no transaction costs. And you were able to do a lot more things than you could do in the stock universe, where effectively you're limited in the timeframes that you were trading.

You had to focus on longer timeframes because of the transaction costs. So moved into futures testing, which at the time, it was quite easy to get daily data on futures and it was definitely plenty to get going. Yeah. Things have evolved a little bit since but... Do you think investors business daily should change their tagline to this is quite entertaining? I don't think that's the angle they're going for. Yes, I mean that most of Wall Street is really a sales organization. It's not

here to provide particular value. I think it's here to sell investments to the public. It's a conduit. It's not here to necessarily... whatever is easy to sell is going to pass through that structure and not necessarily what's best for investors. Yeah, I've written that in a paper before our blog post of instead of the military industrial complex taking over,

we had the financial industrial complex taking over that's just there for the relentless bid right they're always going to be pushing and pushing that's what they get paid for so uh they don't get paid for performance typically uh and so i'd never known you were a domer too usually that's the old joke how do you know someone went to notre dame they'll tell you yeah so you've done a good job of not telling me that over the years yeah it's secrets and so tell and so what it's and then quest started in 99 or was a little in 2001 99 I started a firm called enterprise with a partner

and in 2001 we split and I started quest in 2001. Got it. And then, right, the previous firm, you had a lot of money from MF Global, or not MF Global, but MAN. MAN was at Quest. So MAN invested in 2003 until 2010. Correct, the founder of MAN. And so that was from your previous work and had made connections

and they believed in what you were doing and say, hey, we'll seed this essentially? Well, we cleared through them and somehow our broker passed our information over to the allocation team. We connected and things made sense. And they started with a small allocation that grew to over 500 million over the years, and they took 90% capacity rights at the time. So for a while, we didn't have to basically have any outward-facing efforts in terms of communicating with investors or anything like that. It simplified our lives substantially. It was a good cycle.

A very successful relationship very profitable for everyone yeah it's almost like if you could draw it up in a lab that's how you would do it right of like let us focus on our models and our building the pipes yeah a few years before we have to get into uh right like investor facing raising money all, all that stuff. Yeah. Although I have to say, I really enjoy my investors today. I think that over time, you know, I think that the tendency for a startup hedge fund is to try to please investors, you know, at any cost. For us, because we had the chance to kind of like define ourselves

without having to do that we have a much more i would say defined character which is not the kind of average hedge fund type and because our character is so defined we also have a different message and we're attracting people who believe in our message and the interaction with the investors is actually very important in helping me i would say first help me understand markets and get a perspective that I wouldn't get from people working within the firm typically. So the interaction with investors today is something I value tremendously as a two-way information exchange. Yeah. And I feel like it might have helped that you were a bit of an outsider, right? And then kind of brought these outside views to the space instead of towing the normal hedge fund line, so to speak. Absolutely. Like growing up in a coming from a different background, experiencing different types of risks made me look at the world very differently than a typical guy who grew up on the upper side in New York and jumped into finance and had family in finance etc etc I was very I felt very comfortable

being outside of the herd yeah reminds me of Rodrigo Gordillo at Resolve Asset Management grew up in Chile and they basically confiscated all the assets and his family's all his money got and he's like this is a risk that no one else thinks about in this world but it's a risk um and so what what's it like once you went over a billion was that a big milestone for the firm for you right like it's crazy to sit there and think like i mean you know is it a huge responsibility i manage a billion dollars plus of other people's money. What's that like? Give the listeners a little piece of what that's like.

I'm going to say I live in a different reality than most people where I don't look at the score very often. So I don't know what's happening on the outside, whether like how much money we're managing or our returns. I'm very focused on doing the right thing every day at a micro level, being extremely attentive to detail, almost paranoid. Growing up in the war, you're very, very sensitive to certain risks. You have to be watching out with a very different level of attention than most people. And for me, it's my everyday and the quality of my actions, the quality of my mindset that I'm focused on, everything else is downstream from there.

So, of course, when you grow, the complexity of every decision is exponentially larger and you have to develop models and systems to handle every decision because you cannot be making all the decisions that are far reaching in every corner of the firm. So the complexity got much worse, but i wouldn't say it felt different to me my focus has remained the same i mean uh it's very internally focused focus more on myself being very sensitive to what i see and perceive myself not being affected by what's going on out there and as things are thrown to us, we just have to handle them one by one. And with a clear mindset, I don't see a billion, 10 billion or whatever it is as being the obstacle, right? Today we're at 1.8, but... It helps being systematic too, right? Because you were doing 30 crude oil contracts 15 years ago. Now you may doing 300 but it's just right it's just a number

it's just systematically going into the market yeah we're we're often like one percent of the volume on you know gold crude even the us bonds once over we're actually quite large for a small firm or so you know for a small firm like us um yeah i mean, again, nothing happened. It was not a big step up. It was a slow, gradual increase. So we had the chance to adapt and learn. And of course, it's really important to maintain a beginner's mind and realize that you're going to grow to the place where you really don't. I've never done this before type of thing. And I'm always learning.

And there's always great role models out there so i've always looked up to you know the people who did well in our industry and even though i wasn't connected to them i you know read what they wrote listen to their interviews uh try to put myself in their shoes and and understand what they knew what they did right and what they didn't do right and that sort of thing. So if you keep an open mindset, I would say that the growth is there to be had. It becomes problematic if you're afraid, if you think that you're trying to make yourself right, you want your ideas to be right, you want confirmation from people around you that the way you're thinking, the way you're doing things is the right way of doing things, then

growth becomes very, very difficult uh then reality and and you start clashing quite dramatically the softer you are you know uh the easier it is to to grow right sounds like they're not going to uh model a character after you on on the billion show anytime soon right they want the guy who's like yeah i hit a billion and i'm on at the kentucky derby and uh you know on my jet and showing up soon, right? They want the guy who's like, yeah, I hit a billion and I'm on at the Kentucky Derby and, you know, on my jet and showing up. Let's talk, you've mentioned the word mindset a few times. You're part of a few foundations that focus on meditation and mindset. Tell us a little bit about what you're doing there personally and how it ties back to the firm.

Yeah, well, you know, like I grew up, I didn't, if you look at me as a kid, I was like a shy guy, average grades, not confident. I was like very, you wouldn't have seen any signs of success in my future, right? You say, okay, you know, nice guy, but nothing special. You know, when I came to New York and, you know, my dad died at a relatively young age for me. I mean, and I had to take care of my family and that type of thing. I said, you know what, I'm here, I'm working hard. Let me try to make something out of this. And I looked around and I said, what are ways where you can take somebody who's relatively average like me and turn them into something? And I tried many different

ways of improving myself and I felt the techniques, the philosophies, the practices within the realm of meditation were the most useful in that regard. First, they helped me handle stress much better. They helped me maintain an independent mindset, very present moment, very realistic, not philosophical or idealistic in any way. So it made me very, very sensitive

to my environment and things. Also, the creativity that came with meditation was quite tremendous. I was able to think things that were not taught to me. So it wasn't a question of repeating what was given to me. And literally, you know, I would say a lot of decisions were made out of intuition, out of nowhere. So very early on in my life, I started the daily meditation practice in the morning.

And, you know, you get up at like four or five in the morning and you're doing an hour, an hour, an hour and a half of practices and meditation and some other things to, to affect the, affect the mind. And out of nowhere, you have all these ideas that relate to what you really need to do come up. I feel very, very early age was we're talking like in your twenties or in your early twenties, early 20s um so so it wasn't a question of like intellectually understanding things uh i would get these ideas literally as hunches and uh it came at times where i wasn't trying to think or i definitely was uh the

priming of my mind was not based on what i knew. It was in a world where I know nothing, I'm just observing my mind, and I can observe my mind or somebody else's mind, etc. It was a very, very neutral observation and a very neutral space you're in. In the morning, I typically got all of my best ideas, and the workday was really a question of implementing what came up to me in the morning. So once I'm in the office, effectively I'm going to say I'm not really thinking, I'm kind of grounding and expressing and implementing things that came to me in the morning. So very very different than hey you know so I didn't have like a you know a strong support structure or mentors and

things like that to actually guide me uh the guidance really came in the morning in my in my early hour you know in the early hours of the day during my meditation and that's all that's fascinated me of like you'd think where do those ideas come from right like if they're they're coming from somewhere i think it was i'm trying to remember my philosophy days of Immanuel Kant or something. He said all these ideas are in the ether and you kind of just go, your brain can go up and grab them. But to me, like the physical wetware in there needs to have that. It's in there somewhere. And maybe meditation just opens the pathway to grab that kernel that's been building in the back of your mind. I mean, the thing is not to look at the

world through your own beliefs or through your own ideas or through your own calculations, because all of these are very limited. They're actually randomly put in you based on your experiences. And the way your mind calculates is typically based on your value system more than on the accuracy of what you're actually doing so to really understand how your mind is going to think your mind is going to try to basically justify your like your value system and your beliefs it's going to see what it wants to see rather than what is really out there so really meditation is a question of saying you know what let me just observe and be the the most passive as I can be the most receptive I can be rather than

trying to project and make myself right and enforce my ideas on the world around me. And then tying it back to trading like that's especially dangerous right if your worldview gets based on your position of you know I'm thinking Bill Ackman with Valiant or something like I have such a large position, I have to believe that this is going to work out. That's a different system of trading. It's called like, you know, negative skew and negative convexity and Taylor's and all that.

There's a place for that in today's world. And it's working quite well. I mean, some of what it doesn't work is quite a big splash. But yes, it's, a big splash uh but uh yes it's it's um you know over the years so still talking about meditation i practiced zen meditation i did a lot of like silent and stuff it was always beginner's mind beginner's mind like uh if if you face an obstacle it's not a question of going and like hitting it and trying to like punch through it it's a question my teacher always used to say sit more just sit

and meditate more forget about the obstacle just sit and meditate more so um looping back to where we got to this so the foundation that i started to promote meditation and yoga and some of the you know some of the healing sciences around it because these sciences helped me so much i wanted to i always felt that wherever i went, I was talking about these things, whether it's at work or in a social context. Eventually, I said, let me have a foundation that promotes these things naturally. And that's how these things came about. I also work with the David Lynch Foundation on promoting TM,

which I think is, in the context of somebody who is living in New York, et cetera, I'd say it's the best and easiest way to meditate without having to spend years and years learning stuff. And give us a quick down and dirty on TM. I wish I had bumped into it earlier in my life. Let's put it that way. But it's basically a technique where twice a day you're meditating for 20 minutes with a couple of minutes of just sitting still,

once in the morning and once in the afternoon. And you're typically, effectively, very, in a subtle way, repeating a certain sound mentally in your head. And effectively, it's a way of relaxing your body effectively to hear that sound you need to let go of your physical holding on and your emotional holding on and your intellectual holding on and as your sensitivity becomes more and more subtle you enter a very very peaceful state which is very I'd say easy to recover in and get a new perspective on things. This is an actual sound being played in the room or something or you're finding an internal noise?

You're actually thinking a sound but in a very subtle way. You're not forcing the sound, you're just allowing the sound to be there eventually it's kind of an automatic thing that you hear and sometimes it starts relating to certain internal body sounds such as the heartbeat or the breath or whatever not necessary and when you effectively you're trying to be sensitive to something very subtle and very quiet within yourself and your whole all of your kind of active systems in the body let go. And I found it to be very useful.

And, you know, I've been to India 17 times, spent weeks and weeks doing all kinds of things, torturing myself, learning different things. And I thought the TM was really excellent in a very, very short period of time. Something you can pick up and be quite and get an advanced effect without much effort. My wife's cousin's husband does this three-day meditation where I don't think they eat or they sit there. That seems extreme.

Have you done something like that? Yeah, I've done the 10-day version of that. 10 days. Yeah. Very, very important experiences for me like again every time i faced an obstacle let's say like my father got sick and eventually he died or we were like we were losing men as a client or whatever was going on i'm like i don't know what to do with this and i didn't have again resources whether it's you know financial anything so it was always let me go and spend and do a silent retreat or something.

And then when you're there, you're effectively looking at the world from a completely different perspective. And you have this internal strength where you know there's a leap that you can make. And then over time, if you hold that mindset, then more and more ideas, more and more concrete steps come along the way to show you how to get there. But you get this deep conviction that you can go from here to there although i don't know the steps they're going to show up just because i have the energy to get there so if you get that that type of uh that type of energy and uh it's always worked and it's worked for it seems for thousands of years

and the amazing part to me is you come back to the hedge fund rat race so to speak right like a lot of people go into that meditation do that and come out and say like i'm i want to sail the world i should be doing something different with my life um but that's the amazing part that you're segmenting it and saying you know bringing it to the firm and making sure it's not a place where your soul is getting crushed or whatnot yeah i, I mean, it's very easy for, if you're a meditator, to go into these like new age ideas of manifestation and the world is this and positivity and all that. For me, it was always a question of balance.

How can you take the energy and the perspective and the subtleness of meditation and apply it into the real world to see whether it works or not? It was not a question of you living in a dream or ideally it was really a question of seeing the world like it is and being extremely effective in the world and going back to how we started you know here i am an average guy who grew up in a you know in a war zone with you know being exposed to some very traumatic events comes to new york very competitive place

and in an industry where i know nothing i'm able to function with very very little outside help based on these techniques so it's you know quite a many for me it was a very very meaningful thing that came into my life i love it um all right if we have any listeners left after that let's get to the uh let's get to the program and then but i will say one thing i've talked to a few guys at your firm so you're starting to have the whole firm do it a little bit too right it's an option for people so i don't want to impose it on people but as people face obstacles say hey you know try this uh and try reading that book and try to try taking that course it works it works it doesn't doesn't so you know i think

it stops some people other than me yeah i'm gonna try it after this not right after this but some sometime soon so switching gears give us the uh you guys have a few programs um but give us the 30,000-foot overview, the elevator pitch on the main program, the AlphaQuest original. Yeah, so the idea in the AlphaQuest original is to generate returns. Most hedge funds generate alpha by exposing themselves to tail risk. So effectively, the more tail risk you expose yourself to, the more alpha you have, the higher your Sharpe ratio. And in the context of a bull market, that's not a problem. But when you take the whole equity market cycle into account, you see that you pay very, very

dearly for that negative skew once every three years, five years, 10 years, once central banks are less active in the market. So we took the approach that effectively because of what central banks are doing, volatility is very cheap and people are selling it almost at any price in order to achieve an alpha, which investors then perceive to be skill-based. So basically we thought that approach seemed to be working very well. I don't think it's a long-term stable approach, but since the volatility was very cheap, so we started saying, hey, let's trade futures at moments when the volatility was compressed as a byproduct of people selling convexity or selling gamma or buying the dips or buying illiquid

investments and distorting prices so we're effectively looking for cheap volatility and what we've managed to achieve is returns which are you know very strong like double double digit returns while being long skew which is very very rare in the hedge fund world yeah and but which came first so you started looking at futures the original program was it more of a hey I want to do trend following because it fits with my personality or was it deliberately like I want this positive skew back in the beginning? Well I didn't know what skew was when I started but actually before trend following, trend following was always there but i would say trend following entered much more uh in the mid-2000s after the total systems became public

and all that for me what the way i started is i bought uh from uh i saw a little ad in investors business daily i think it was like five dollars little booklet, which was maybe like five pages, called Opening Range Volatility Breakout. It's literally, and it spoke about basically trading, you know, the open of today plus a multiple of volatility, you go long. Opening of today minus a certain multiple of volatility, you go short. And you exit a day or two days or three days later. And you do it in particular when the vault is compressed. So that's basically the idea I had started with.

And then trend following was obviously super easy. You can do it with, you know, whether it's price momentum, channel breakouts or moving averages. So then we diversified into trend following and then it was a combination. Then over time, it became harder and harder to trade short-term and transaction costs became more significant so then we became more and more adept at filtering trades in a way that's stable.

You definitely are to this day are more of a shorter term right than a lot of the peers of like CTA index or something. I would say you're on the shorter term scale uh so we it's not a it's not we're not committed to being short term we are short term and we're going more short term just because of the market opportunity effectively so if you look at the trading system time frames like how long you're holding the trade on average, if you trade very long-term, markets are very negatively skewed today. It means they typically climb slowly and reverse very fast, which has been a problem for long-term trend followers.

So long-term trend follower indices, which used to be positively skewed, today are no longer positively skewed. They're not able to provide hedging for equities. Effectively, long-term trend followers have missed three or four of the last equity corrections. We saw that long-term trading is no longer positively skewed. Very short-term trading is more, because of transaction cost

sensitivity, is also typically needs to be more mean-reverting in nature and more market-making type. We saw that seven to ten days is a time frame where you're getting the most positive skew and you're also less exposed to transaction costs than the shorter term timeframe. So we stuck to that timeframe. That's why we're kind of like short term.

It's more because of the validity of skew and low transaction costs in that timeframe. But inside of that is kind of a little bit of classic type trend following, some of this volatility breakout type models. What else is included in there without giving away all the secret sauce? I wish I had secrets. But so over the years, we started with basically literally the model I told you. Look at the average true range of the last two days and then add the multiple of that number to the open to go long on a stop and deduct the multiple of that from the open to go short and exit two days later. Literally. We traded the same thing we called it i-swing back in the day. It was pretty good. Yeah. So the way things have evolved for us is, you know, people in general today,

especially with the advent of machine learning and you have thousands of quants graduating every year from all the different grad schools and all that, you can teach trend following to high school interns at Quest. It's kind of like their first week project, right? And you can replicate the CTA indices with literally those simplistic models. So what can we do to generate alpha? You look at the short-term space in particular,

all these guys are trying to create alpha in 20 years since we've been around, I would say probably one out of 20 or one out of 30 firms is still alive. So very, very risky business model. Especially in the short-term index, it's even higher. Correct.

So the way we evolved, where most people are getting more rigid in terms of optimizing, so they're looking for models that are more complex, trying to go deeper into the understanding of how markets function with the belief that market stability, if you go deep enough that you can understand market structure, and that's going to provide you with stable alpha.

Okay. Like if I have this smart quant, he's going to come, he's going to give me a model with a Sharpe ratio of two, and that that sharp ratio is going to cut you. Now, the reality is 99 times out of 100, that sharp ratio of two ends up being or flat or negative when you start trading. And it's not a question of over-optimization or that the models are too complex and they've misjudged the level optimization, and it's just purist returns that they had in simulation. Not at all. It it's more a question you can do the same thing on uh quite simplistic models that are not over optimized the what we do is we're assuming and it seems that matches reality that the moment a factor has worked

due to the you know advent of quant trading and machine learning and all that uh there's a lot of capital which basically follows the idea or the fact, and very quickly the factor becomes overpriced or crowded and stops working. So it's not, if quants hadn't chased the factor, it would have continued working. But the fact that money came into the factor, it stopped working. So try it on. Sorry, just even if it's not published in a paper or whatnot you're

saying there's so many quants they're gonna arrive at the same conclusion almost simultaneously and put that correct correct there's so much intelligence in the market and optimization and computing power looking for what has worked whether you understand what has worked or not in particular today where most of the alpha numerical alpha i'm not saying skill based alpha but the numerical alpha which is produced in the market is due to tail risk even if things look uncorrelated the moment the market goes down the volatility increases against you the losses go get you know basically you lose money faster and faster the correlation increases and you get exactly the opposite effect of than what you thought okay so i was just going

to say you reminded me of a paper by ben hunt i don't know if you ever read his stuff but uh was saying the market you know everyone's thinking it's a clockwork machine and if i could just figure out the gears a little bit better i could beat it and he's saying no it's a bonfire and you can't really model it um so you can try but this is kind of those two thoughts at the same time one it's not a clockwork machine but people are still developing models as if it were and that's crowding out those models uh human behavior humans like confidence they always thought since they were kids to believe their own ideas. And the more evidence you gave them to believe something, such as a very powerful backtest, the more confidence they were and the more money they would allocate to the idea.

I haven't seen many investors who don't follow that process before investing. So show me your simulation. So that is very, very predictable. That's my old saying, nobody ever lost money on a spreadsheet. Well, the thing is markets are much less liquid than most people think, or it's much less liquid

than most investment managers tell their investors. So effectively, if somebody tells you, you know, our capacity is a billion dollars, assume it's going to be three or four hundred million. Most people underestimate the market impact that they have, not only from a transaction cost perspective, but from the perspective of impacting the long term behavior of markets. Right. And that's really we're talking, you know, very meaningful stuff here. Because why do thousands of quants who design even simple models eventually cannot produce true alpha in the markets? What is it that happens between the simulation and real life? And most quants don't ask themselves that question.

They're very confident of their ideas, but then once the returns are not there, they just keep coming with new ideas, thinking the next one is going to work, not understanding that there's something extremely wrong in the thinking itself and the process of optimization. Not over-optimization, just plain optimization. Historical return analysis distorts markets

in a very predictable way. Right, which is a fancy way of saying past performance, not necessarily indicative of future returns, right? Like it's, you can model it, you're feeling good about it, but it's not gonna, history is not gonna look the same moving forward. Well, it's likely to look the opposite of what it was, it's too many people believe in it. Definitely. And let's go back to the ske of what it was. It's too many people believe in it. Definitely. And let's go back to the skew for a minute. So, and this was an interesting thought.

So you're after positive skew, you're after convexity in the model, but you're not using options, correct? Correct. So most people think of convexity by buying an option for 10 cents and selling it for $10 or something, right? It geometrically increases. So if you're just doing futures and Delta one, how do you get that convexly? How do you think

about that? Well, most markets have embedded optionality in them. So suppose your short net gas in the winter months and long net gas in the summer months as a spread with a looks like delta one the reality is the risk on the in the winter months is multiples of uh the risk in the summer months the volatility of the two is typically the same but if you have a real shortage of uh net gas in the winter you're going to have a massive distortion in that spread so what ends up happening is the winter months trade more expensive than the summer months. And then there's a possibility of net gas going from two to five, where you're not going to go from two to minus five. So effectively, all markets, equities is the same. Equity indices, as the market goes down, the leverage, the corporate leverage, investor leverage, portfolio deleveraging, all those things kind of accentuate the moves.

And you have much higher volatility on the downside in equities today than you did on the upside. Right. In a bear market, you have the opposite. You have upside increases in volatility and very slow down moves. But today, effectively, convexity exists in all markets due to the internal leverage of the position itself, such as the equity to debt ratio in a company, but also due to the volatility assumptions that most investors make. If you trade risk parity and your position sizing is inversely proportional to three-year volatility, volatility increases when the market is going down. You have to sell, which accentuates the volatility, and it's a very self-reinforcing thing.

So today, the Buffett ratio, the market cap of equities to GDP is about 1.5. It's the highest ever. And effectively, that means that every time the stock market goes down 1%, it has about a 1.5% effect on GDP. Right? So effectively,

the tail has gotten heavier than the dog. And the thing that depends on the dog is actually literally wagging the dog. So convexity is highly correlated to this type of leverage. So if you want to predict skew in the market, the Buffett ratio is a very, very good predictor of skew. But as I think of it, if I'm graphing, right, if I have my trading model, I go short the S&P, whatever, on a breakout. But if I graph that, right, the profits I can make is just the straight line up, right? It's not a convex. It doesn't have that curve to it. But you're saying

the ability to get from here to here on the line is because the market itself is going to show this convexity. Correct. The market volatility is not stable. It expands in a predictable way. So is correlation. Correlation is not stable. It expands in a predictable way. So is correlation. Correlation is not stable. It increases in a predictable way based on skew. So if you look at two markets that have zero correlation and producing alpha to the S&P, they're highly likely to be negatively skewed, which means when the S&P goes down, their correlation to the S&P is going to increase, their correlation to each other is going to increase, their volatility is going to increase, and you're going to have to deliver while all that is happening.

Yeah. Okay. This is very, very predictable. So you don't need to have... March 2020 is the case study. That's one of them. Yep. There's been many.

I mean, that was a multi-week event, but you have those events intraday. So you say, well, there hasn't been a real correction. I don't know what's negatively skewed and what's not. And how do you measure skew? If you look at the market short term and off, you will see that the way the volatility of markets changes is highly predictive of what's going to happen

when there's a real crisis. So something can look very, very stable, very beautiful, tons of alpha, whether it's an asset or a hedge fund strategy or trading strategy, but you can predict the lack of stability even in stable times based on looking at skew. I'm going to say that the alpha of the hedge fund industry is completely explained by tail risk. It means you can replicate the hedge fund industry is completely explained by tail risk it means you can replicate the hedge fund industry without any skill if you take skew into account yeah i was

going to go there next and ask you right we talked a little bit about this of uh right hand in hand with all this is the rest of the world is kind of focused on positive, sharp, consistent returns, you know, what we call negative skews. So you're saying that's not necessarily these hedge funds aren't dumb. They don't not get it. They're just giving the people what they want. Or are they blind? Again, if you believe what everybody else believes, you're typically going to end up in crowded positions and situations. Today, there was a lot of evidence that Sharpe ratio is a great measure of risk-adjusted returns. And people are chasing Sharpe ratio. Sharpe ratio doesn't

measure tail risk. It effectively encourages you to invest in funds that have a lot of negative Sharpe, negative tail risk. And effectively, Sharpe ratio is a great predictor of very large drawdowns. So things that have a high sharp ratio are very likely to reverse with drawdowns which are very large multiples of volatility. So we're saying something that has positive skew will have drawdowns which are one, one and a half, or two times their vol. Assets or strategies that have large Sharpe ratios will have drawdowns which are four times, five times, six times their volatility. Okay, so Sharpe ratio is a great predictor of large tail risk. Alpha,

which is correlated to Sharpe ratio, is highly, they're all 80, 70, 80, 90% correlated to tail risk. So effectively, what investors perceive as skill or what they pursue in the form of high alpha, high information, high Sharpe, is purely, literally a byproduct of tail risk. And is it fair to think of that as like they're borrowing risk from tomorrow, right?

Or they're pushing risk from today into tomorrow. And so you're just not seeing it yet in the track record. Correct. Now, in most cases, asset management is more institutional than it used to be. So typically somebody else is managing your money. And therefore, there is a misalignment of interest on the downside where the asset manager participates in the upside but doesn't participate in the downside. So these type of markets encourage a lot of exposure to tail risk where effectively the asset managers are not participating in the downside. So it encourages the you know, the

selling of convexity, the selling of gamma at any cost. It doesn't matter whether I'm selling insurance, you know, below accrual value, because the risk is only going to show up once every 10 years. And by then I would have made tons of money on my business. Right. So it's now that's the wrong business. I did, but so far, so far so good yeah exactly despite the discipline that we've imposed on imposed on ourselves and part of me though thinks like maybe they're the cleverer by half right maybe they figured it out of like and they would maybe argue like yes we're doing that but we have this huge fed put there's this huge the financial industrial complex we talked about that's going to swoop in and keep buying so how do you square all that of like

maybe they're right because yeah they're negative skew but the downside isn't all that really isn't all that dangerous yeah they have been right yeah so there's no question about that it doesn't mean that investors i mean it's basically easier to make money being short uh short convexity but investors don't have to go along with that if they have investors can make the same alpha being long convexity they should choose that in fact investors should basically use convexity as part of their risk analysis. If you tell me I can give you a low quality product and you're buying it, I'm going to say, okay, good enough.

If investors have higher standards and look at risk correctly, they're going to see that they can do things in a much more transparent way with cheaper fees and with less risk. And I remembered what I was going to ask before, when we were talking about the ability to do it with positive skew. How do you, back to the model, how do you accomplish that when, right, coming off of March 2020 or similar when volatility is so high, right? We talked about the best time to do those breakouts is kind of when vol is low.

So if all those correlations are up, all that vol is up, you've realized the positive skew. How do you keep that positioning on without getting a huge bleed out of it? Yeah. So in the concept of crowding, we're evaluating within one sector, which markets have overreacted from a volatility perspective? Where are they on their gamma curve, and then which sector relative to other sectors is most overpriced from a gamma perspective, and also which trend following model is overpriced relative to other trend following models or which time frame is overpriced relative to another. So effectively we have many dimensions where we can expose ourselves to trend following in one sector, in two sectors, three sectors, in one time frame, using a certain type of trading methodology or in specific markets within a certain sector. more exposed on the upside and less exposed on the downside, where we ended up achieving more alpha than funds,

which are short-convexity with positive convexity. But there's no way to cheat, right? If all those models move up and they're at the peaks of their gamma, you're going to be more lead by definition, right? You either have to move to the sidelines or trade the least expensive of them, but it's still expensive. It is more expensive once the, you know, there's been a 5X multiplication in the vault. It doesn't mean that you should no longer be exposed. Again, we're going to go into, I guess it sounds like we can go into a bigger picture of what central banks have provided.

Well, let's hold off on that. But yeah, I was just on the model side of how do you view that? But you're saying like, no, we're not trying to time our insurance or time our skew or anything. It's essentially always on, but dynamically shifted to keep the drag or the bleed as low as possible.

You have to have bleed to be long convexity, except you have to do it in the cheapest way possible. And if you're evaluating effectively, you can replicate CTA indices with purely with moving averages, 90% correlation. Now, how is one trend cheaper than another? I'm saying the volatility expansion that's happened is a very good way of predicting how expensive a trend has become brought to other trends. And do you look at that all as kind of an option pricing model or no? No, we don't look at implied vols whatsoever. We're looking at realized vol only. Most liquidity needs of investors are correlated to realize volatility, not implied volatility in markets. And I want to come back on all these other investors and allocators and hedge funds trying to deliver this high sharp.

So some would even do things, would you say, to improve their sharp? Like if you weren't you and you were some more nefarious or trying to build a great sharp model, what would you do kind of end of month or inside of different months? You could goose the sharp a little, right? It's very easy to improve sharp ratio by selling out of the money optionality, right? So one way is to buy the dips, effectively to have a negative gamma profile.

So the more negative gamma you are, so there's a kink in your beta curve. You're more correlated to the S&P on the way down and on the way up. The bigger that kink in your beta curve, the more the gamma, the higher your alpha. So you can improve your alpha or your sharp by buying the dips faster and selling the rallies faster effectively. Another way of doing this is if you're trading illiquid instruments is to do window dressing,

which is quite easy in stock. So if I give you an equity book, which is leveraged three times, you can month end move the stock price half a percent up or half a percent down, depending on your portfolio needs. So if you're down, you want to push up the positions slightly, price them up. And if you're up more than you need, you can basically sell them in order to keep returns for next month. So by smoothing returns that way, month end or quarter end, depending on your pricing cycle, you're able to take returns which are correlated to the market which are replicable

which are uh which should be you know replicated with low fees and make them look like skill-based returns so now your returns they're very very correlated to the market but in the time frame where your price they're not correlated but in reality they're highly correlated now tailors will tell you how much of that you're doing just because of the window dressing and and then and there's people actually doing that as far as you know or who knows that's how you would do it wait wait of course i mean it's not uh by the way some of these things are called portfolio rebalancing they're not called the window dressing yeah um and then how do you how do you so if i'm a investor i'm putting together a portfolio of hedge funds or whatever, and they all have great sharps. I don't see any negative skew. Like, how do I go about I have a little inkling there's negative skew there.

But how do I go about kind of assessing that what that price is? What How can I assess that risk? It's a complex analysis, but look at things which are correlated to your hedge fund, which are going to, if you don't know what your hedge fund is doing, look for replicators. And the replicators, which typically have higher transparency

and higher liquidity, will tell you what's happening intramonts, which you cannot perceive in the NAV of your hedge fund. Right. Right. Right? In most cases, a short VIX is a good benchmark to model the negative skew of most hedge funds.

Right? So you can use a VIX future or that type of thing. That's one way. But remember, alpha and tail risk are about 80% correlated. So, the tail risk is there. The question is,

are you measuring it in the right timeframe? Right. And I just think of some managers I know of who've been selling like weekly options for since the 09 bottom and there hasn't really been

a 10% weekly move. Even March 2020 was sort of contained um right so they they have a huge sharp it's like a four or five sharp you know under the hood they're selling options there's negative skew but it's never shown up yet in 12 plus years so it's like how do i assign that negative skew value to that and like you said i could what's it look like how is it correlated to the short vix in every day or something like that yeah there's different dimensions to this problem and i would say the option guys who are doing it in a less visible way typically underwrite at the money uh weekly options and go long long term out of the money options

effectively they'll tell you we're long volatility and long skew and we're getting positive alpha and positive carry now the risk is

if you have short term reversals which sustain themselves for a long time then you will actually see the tail yeah if you get

middled I would call it right okay it didn't explode and pay out on your calls, but it didn't drop. So it's right there in the middle. Yep, yep, yep. So there are ways to hide some of the principal risks of that trade, effectively what I'm saying.

But most hedge funds, the hedge fund industry overall doesn't. And then moving on, we talked a little bit about this. I had it as a separate topic here, but we can touch on it again real quick. And one of the things I've always appreciated about you and Quest is you're playing the players, not necessarily the game itself. I feel like a lot of people are modeling just the markets. They think that's the way to go. So tell us a little bit about how you think about that. And is it literally like I know that there's going to be

10 000 contracts when this breaks this moving average so i'm going to stay away from that or is it a more philosophical uh approach well uh there's the belief that markets are made up of human behavior and human behavior is much more predictable than markets. Human behavior asset allocation is driven by confidence. It's driven by investment committees. It's driven by evidence. It's driven by Sharpe ratio. And those things are things that you can actually measure systematically. So effectively, based on the character of the equity curves

of certain strategies or markets, we can predict inflow of capital, the effect of the capital inflow on transaction costs and on the overall behavior of the markets. And it's an easy example of like the growth of risk parity and how big that's gotten. So risk parity based on the current realized volatility and correlation of equities and fixed income, you can predict how large risk parity positions

are in equities and fixed income. And you also can predict what the rolling realized volatility is going to be once the market starts to drop. You can predict the liquidity needs of such strategies once the market starts to go down. And you can predict the impact on how risk parity is reinforcing a bull market in equities and fixed income when the vol is compressing and they're constantly adding to their positions as well. And in that example, will that allow you to hold on to a long position a little bit longer or how does it feed back to the model? Well, if you want negative skew, there is a part of... Yeah, which none of us do on this pod. We want positive skew here.

Well, you have to understand both sides of the equation. So let's say you take a Robin Hood or something. There's ways to manipulate a stock by bringing in retail slowly over time, because as you create a momentum idea and you create media and you create a frenzy around the stock, you can create a thing that will attract a lot of retail interest in something, which will create a bubble which is quite substantial and meaningful. Whether you have an investment

club, or you write a newsletter, or you're part of business daily, whatever it is. There's an aspect of stock manipulation which is always happening, which has the ability to create alpha because the alpha and the way you trade is more directly related to the market and people who are

responding to you don't exactly know your signals and you typically exit at the top and basically leave other people hanging so there's a momentum trading right sector rotation you want to call it or a factor rotation blah blah you know like all that. A lot of that is, you know, you have firms like AQR managing tens of billions in factor, you know, factor. It's a huge strategy, which effectively you're chasing returns at high leverage with very high transaction costs, right, in market neutral positions. So if you understand that, the impact of that is very, very, very meaningful. And our job is to predict it.

Yeah. And right, the old line, if you don't know who the sucker at the table is, it's probably you, right? Yeah. So you have to, there are many aspects to skew. Crowding is very important.

The confidence is very important. These are all things that are like predictable and measurable. And what are your thoughts on as there's more and more AI models and kind of black box and they don't really know how the returns are generated. Will that result in less predictability? It results in more monothematic thinking, right? So more exposure to certain factors, which the final investor is not aware of.

It results in less transparency, effectively. So an investor thinks he's investing in AI. He doesn't think he's investing in risk parity. And risk parity, things that are investing in AI, he doesn't think he's investing in risk parity. And risk parity, things that they're investing in risk parity, they don't realize they're investing in the Fed. All right. And my thing is, even all these AIs, won't they, you know, if you eventually have the same computing power and everything, won't they all come up with the same? I mean, I know there's a million different inputs and the human

biases built into it. But in theory, if they're all equally powerful AI, they're going to come up with a similar result, right? Yep, yep. Like in 2017, the Sharpe ratio on a short VIX, I think, went to 15 on a 12-month rolling basis. Sharpe ratio of 15. And a lot of quads effectively started bottom picking the stock market, the VIX, in multiple different ways. But effectively,

all those strategies correlated. I think it was Feb 18 you had that vol crash. VIX, McGill. Correct. So effectively, you're creating opaqueness, you're justifying taking correlated positions and creating a cloud around it so it doesn't look like you're doing something which is simple and replicable.

So AI is great because it can help you automate decisions, but you cannot give it the ultimate power to have common sense and understand crowding. AI is purely replicating the past, and it's highly likely to lead you into crowded positions. So over the years, the complexity of modeling of markets has increased substantially, but the complexity has not improved the risk, it's just returns of investors. So it's where you stand relative to markets and today the fact that AI is free, pretty much, Means that's the benchmark technologically. It's not going to give you an edge in itself. It depends on how you apply it. You have to apply it in a way which is differentiated

from the rest of the market in order for you to provide liquidity when the market needs it and take liquidity when the market is providing it to you too cheaply. Do you guys use any machine learning or anything to crunch the data? A a little we don't have live learning but we use the learning in the simulation process and the design process so there's certain aspect of our thinking in the research process which is easily replicable

and ai is a you know quite useful there but we don't use it at a high level to decide what we're actually going to trade. We're using it to think in a very limited way in narrow buckets of thinking which are not related to market crowding. It reminds me of there was a big article on Mann AHL's AI and the example they used was

it bought the dip when Trump got elected in the market dropped and they bought the dip, which is just speaking to what you're saying. It ran the past history and it said, buy all the dips. It worked that time doesn't mean it's a long-term risk-adjusted positive trade. Correct. AI is not well suited to pick positively skewed trades. Couldn't you make that one of the inputs that will only give me positively skewed trades?

It's not going to happen naturally. Yeah. Right. Or it would give you that weekly, right? It would give you this was positively skewed. Doesn't necessarily mean it's going to be positively skewed doesn't necessarily mean it's going to be positively skewed you need to rely on very uh fine tuning to use ai to pick positively skewed trades uh and how do you which circling back to the model how do you identify which are the positively skewed trades it's just that it's not risking more than it's looking to make? Or is it more nuanced than that? Actually, in the case of system design, skew of daily returns, skew of monthly returns

is quite simple statistic to tell you whether the model is positive, skewed, or not. And then you can look at the degree of risk on, risk off, exposure, and that type of thing. So for models, it's quite easy to see whether something is positively skewed or not. But to me I'm like if I'm just doing a simple trade, if I risk 10 grand to make one thousand dollars, to me that's a negatively skewed trade over time. But in theory if I ran it at the right times in the spec test it might show as positively skewed in the data.

So you have some methodology of saying matching it with reality basically of what the true risk is um the way we trade which is i mean we don't over optimize so the we limit the number of factors that our models have so therefore the optimum over optimization risk is minimal typically where if we have a model that makes money and doesn't make money when you start trading, it's typically the byproduct of market impact. Yeah. And so we don't have that issue. So typically, positively skewed models are not going to easily get crowded because nobody's looking for those. Models which are negatively skewed are typically the ones that attract capital and they get over-influenced.

Right. And a good way to think of that might be like trend following silver. We did an example a couple months ago. It had lost on a simple breakout. It lost like 18 times in a row, right? But lost a small amount. And then the 19th time is a huge outlier move, right? That's a positive skew,

but you're likely no one's going to choose that to put in their portfolio. Correct. They have this maniacal devotion to the positive skew, right? Well, most investors, the most certain thing you have is that most investors chase returns and chase sharp. So you want to do what you're doing with minimal exposure to historical returns and historical sharp from that perspective i want to move on talk a little bit about your uh you guys do a monthly report called the quest book which is quite cool as um right first part of it is like your returns and alpha and all that jazz but then the second half is more informative to me but just economic

indicators the buffet ratio versus this everything you were talking about liquidity measures you know i don't know how many pages it's up to now, like 50 or 60 or something, but tons of information in there. So I'd encourage anyone can just go to your website and sign up and get it. So I'd encourage everyone to get it. There's a lot of great information in there, but talk a little bit, or I'll just start with one thing I really noticed in there was the hedge fund replication, which we've touched on here. But like, how are you guys doing that? It's almost spot on to the hedge fund index, which is amazing, right? There's guys managing billions of dollars and earning billions in fees, and you can replicate it rather easily. it's a quite simplistic model which effectively replicates the hedge fund industry using smps msci index and short vix right so now if you want even more accuracy than that basic model

you take that model and instead of using the smp you use S&P with legs, which means the returns of the hedge fund index this month is also dependent on the returns of the S&P last month and the months before, because some hedge funds report quarterly, so to begin with, and also there's the window dressing component, right? So if I have a little leeway on my illiquid positions to move the stock or the fixed income position month end, I can smooth out my returns. But overall, over the next two, three months, that's going to kind of like average out. Wash out, yeah. So you can actually, when you take that smoothing into account, then you get into even more accurate replication of the hedge fund index.

And that again, so it's cool just to look at, but you're using it, it's tying into your models and where that crowding might be as well. Well, we're not using that model specifically, but the reason we have the Quest book is to, we want investors to be as educated as possible when they come to us. I want them to understand the CTA index, how to replicate it, what components of the index replication are doing well, not well, in order for me to be able to speak to them in a very detailed way in terms of how we differentiate ourselves from the typical CTA. We didn't even get into that, so I'll mention that real quick. As well as the hedge fund indicator, you have the CTA replication, and then you also have a product that people can invest in, right? That's the CTA replicator, low fee product. So my goal is transparency

and look through for CTAs and for the hedge fund industry so that investors come in not thinking that there's like this magic thing out there which is producing alpha, which is skill-based. It really that 99% of hedge fund returns

can easily be replicated with simplistic strategies. Right, and the takeaway for me from the CTA replication is most all that return comes from fixed income and a lot of it can be explained lately by long bias, longer term. So you're saying, and I give you guys credit of you're sticking your stripes and saying, hey, we're not falling for that siren song.

We're going to stick to our knitting, so to speak. So explain kind of what you guys have seen inside of that CTA index of what those performance drivers are. Yeah. So if you replicate the CTA index first, they're using three different moving average crossover. Let's say five day to 100, five day to 300 even are good enough. And you can have we ran an actual replicator which has like 90% or 85% correlation to the CTA index with about 2% of alpha, which is due to the fact that

the fees on the replicator are cheaper than the index. So now what you see there that's like the, and our replicator is more positively skewed than the CTA index. Effectively, CTAs over the years have, in order to improve their Sharpe ratio, drifted into more and more risk-on strategies. So they've added effects carry, they've added credit strategies, they've added bottom-picking equities, they've added more exposure to fixed income and they've introduced long bias.

So if you look at the returns of CTAs or the basic trend following strategies that replicate the index, most of the returns in the last 20 years come from fixed income. Effectively, fixed income and the return on cash explain 100% of the returns of the CTA indices. Second, if... Real quick on that, that's not just the big uptrend in prices,

downtrend in rates, but you're saying the right, earning the T-bill interest essentially. Correct. If you take that for a CTA,

a T-bill rate is very important for CTA. So if you take a T-bill rate out of the CTA indices, where you are today is very close

to where you were in 2003, in September 2003, about 20 years ago. Yeah. Effectively, CTAs have is uh to where you are today is very close to where you were in 2003 in september 2003 about 20 years ago yeah effectively ctas have pretty much made just the risk-free rate in about 20 years 18 years so first it's a mainly fixed income and it doesn't mean that ctas cannot make money in commodities and other things just net net risk rate plus return on long-term fixed income is 100% of the return. Second is close to 100% of returns comes from the long trades. We're living in an inflationary world. So although measured inflation is like 2% or whatever it is,

if you ran a model by mistake, which bought every future contract and never sold it, you would have had returns which are better than the CTA index. A thousand times more volatility probably, but yeah. Sometimes with more volatility. Overall, I'd say a better Shar sharp ratio than the CTA index. Net-net, the CTA portfolio, the assets that CTAs trade, the 80 markets or 100 markets, are appreciating at about 6% a year. Except for grains. But today there. So yeah, coming back to the book, and we're starting to touch on this,

and you're saying risk parity is a bet on the Fed, all this stuff. So what are some of the biggest economic factors you're looking at that are in the book or outside of the book? You know, what the rest of this year looks like and into next year and into the next decade, I guess. I mean, the big one in terms of the way we relate to the outside world and how we model outside reality is by modeling tail risk and how expensive is tail risk.

We're not actually trying to predict the macroeconomic environment, et cetera. But what tail risk, if you look at the skew index today, it's at all-time highs. Effectively, we're saying that the outside world is the riskiest it's ever been, and investors are prone to larger surprises than ever before okay so that's my view of the outside world uh effectively i mean we know this central banks i mean last year we printed about uh four trillion worth of dollars just because of covid outside of the normal budget deficit yeah and this year, you know, we're talking about another six trillion.

Right? So bridges. It's a lot of bridges you have to build and a lot of free money for waiters and all that. Yeah. So in New York, I have friends who run, you know, let's say restaurants or other businesses.

Somebody who's making $80,000 a year is better served being on unemployment than working. The caretakers PPP setup was incented restaurant owners to pay their people for three months shut down then they could keep 70% of the money and open later. So the instability of the money and then open later right? anyway so the instability of the macroeconomic reality is higher than ever. but where MMT folks would say no it doesn't matter it's just adding digital zeros and it's not really going to be inflation, deficits don't matter anymore. Where do you stand on all that? Well, not where I stand, but if you look at the last hundred years,

they're 100% correct. But if you read the history book, they're 100% wrong. So I'm all for Warren Buffett and all these people that say gold is an ancient relic, except gold is the currency which is stronger than the U.S. dollar. It's the longest term currency that's been around. It's more solid than any paper currency. It cannot be printed.

There's an incentive for central banks to discourage people from investing in gold because when you invest in gold, they cannot print gold and take money away from you like they do today with a dollar. Yeah. And I guess, would you say in some of the charts, right, does it even matter if it's right or wrong? Like if it makes the whole system perhaps less stable, if it adds volatility, that's just what you're after, right? I mean, we're in an unstable equilibrium. We look more stable than ever. If you look at the returns of the stock market, et cetera, but we're less stable than ever. When you really look at the factors, which are haven't basically manifested in the market yet.

That's our perfect. It's kind of the same as these guys gaming their sharp ratio, right? Like you're gaming the economy, gaming the borrowing risks from today and pushing it out to tomorrow. Correct. By creating inflation, by printing money and distributing money, asset price inflation gives the perception of wealth and people go and spend and basically it moves the economy. The is they're that first they're going to get taxed very very substantially on their capital gains and second the gain is in

real terms is not actually there it's actually negative so the fact that you made 20 a year and lost three years in the stock market when you really look at it on an inflation adjusted basis it's not that much especially especially after capital gains. Yeah. And then at the end of the day, you don't really care whether you're right or wrong, right? If it's just, it's systematic and, hey, if I'm completely wrong and MMT is real and we're in this Goldilocks forever, whatever, there's going to be some market moves that happen and we're positioned to capture them.

Correct. So our thinking in terms of the outside world is modeled quite simplistically through convexity. Right. So I can spend my days and hire economists and hire and hire Greece and all that. But we don't have to. I think our model of the external reality, we're assuming instability. It's better than assuming stability. Yeah. Right. Right. A lot has to go right for more stability, right? Correct. And so what does that look like in terms of liquidity and volume and volatility in your mind? Liquidity today is much less reliable than it used to be. Effectively, liquidity is provided

by market-making hedge funds, such as the Citadels of the world, that can effectively switch off their market-making operations for a day or after a couple of hours of losses, literally, where before that liquidity was provided by banks that had longer-term perspectives and plans to maintain, etc. So liquidity, I'm going to say in markets is much less than people assume it's highly unreliable and it typically dries up exactly when you need it right and that's it's there on a normal day it might be totally gone on an abnormal day when you need it it's not going to be there yeah so it's going to be the liquidity provider at that point, right? You know, I would say some people should be, but not our job to do that. But there is room to be a market maker when the large ones have basically pulled off.

But remember that because volatility is so suppressed compared to the volatility of the economic reality out there, the vol can expand by multiples and the bid-ask spread can expand by multiples and still not be expensive enough for you to justify market making. Yeah, I saw that. I was playing around looking at the GameStop options when that whole thing was going on. And it was like the stock had to move like 280 in a week in order for you to make money on the on the option the premium was so high so that was the embodiment of that right the market maker is saying you can buy this thing but i'm gonna i'm gonna price it out of this world yeah yeah yeah uh market making has been uh ideal i i i'm gonna say it's almost like an idol today like everybody thinks that it's like free

money it's no longer the case yeah and but to me that's always a weird thing like they can turn it off these days like the banks could always turn it off also are we saying they had like alternative motives or different different well if a bank turned off the market making a desk you as a client would would move your capital. So they had a longer term perspective on things. Their inability to turn it off might be why they're sort of out of the game too. Correct. But they got regulated out as well. Yeah. That was liquidity. What else did we say? Volatility. Yeah.

They go hand in hand, but so volatility outlook longer term. Volatility can go to zero, but the risk in the market can be higher than ever. So when we started trading 20 years ago, the vol on the S&P was 20%. Today, the vol on the S&P is 10%, but the drawdowns are larger than they were at our time 20 years ago. So effectively, vol is being massaged and compressed due to the short gamma exposure in markets. Effectively, people are committed to buying the dips and selling the rallies because that produces alpha. The only thing, that's not the real risk. Effectively, markets don't move in line with economic reality. So if the economy is going up and down and the markets are not moving,

you go, wait a second, are markets really representing the economy or what's going on? So today, markets are unrelated to the economic reality. So volatility, which you measure in the markets, effectively is not really telling you the real risk. The real risk, you still have to look at the economy and go, wait a second. We're more levered than ever. We're making less money than ever.

Our productivity is lower than ever. Money velocity is slowing down. Aging population is going to want to be exposed to less risk. You know, we have a few headwinds ahead of us. But we've seen in like commodities and elsewhere, the volatility has started to pick up. Just realize vol has picked up, right? Yeah.

It might look like we're moving into a, from the CTA bucket, we might be, you know, their 80 to 100 markets might be moving up into a from the CTA bucket we might be you know they're 80 to 100 markets might be moving up into a new vol range. Yes so the world the word inflation happens to be showing up more often than it used to yeah despite what the central bankers tell you and some people are starting to shift away from the dollar which can be effectively you can be uh taxed indirectly every time they print money and are starting to buy real assets as a hedge against that risk right the uh yeah if if i'm an investor i come to you and be like, cool, I'm doing this because I'm worried about inflation, I'm going to invest with you as an inflation hedge.

Do you say, whoa, slow down? Or you're like, okay, that makes sense. I mean, inflation, we tend to do very, very well in inflationary periods. Right. But we haven't really seen them. So how, just in testing you're saying, like in micro bursts testing you're saying? Well, in the Bush years we had a small cycle of inflation going into 2007. That's a good example. So the amount of markets that we can trade and markets which are not controlled by central banks is much larger in inflationary periods than during controlled inflation periods like we are today. So if liquidity goes into commodities and people, commodities actually start to move, central banks cannot print commodities. They can subsidize those

industries such as farming, which they do in order to control prices, but commodities cannot as easily be controlled as currencies, fixed income or equities. Right. So the Fed can't grow more trees to help lumber prices, right? Not directly, no. But I mean, they'll subsidize and run industries at a loss in order to not have perceived inflation. And how far do you think they would go? So we're talking about subsidize whomever.

You think in this last downturn, we saw them buy corporate bonds. Are we far off? Are they just going to outright buy Apple or Amazon and stop some big drawdown? There's no reason to stop. I mean, they have a great business model. They can print money.

You can print, I can print money. So whatever they need to do to maintain that business model, my sense is they will continue doing. For most people, it seems like there's no consequence to that. Again, if you've read history books, you know that 100% of the time, that game has a very, very bad ending. Very bad ending. 100% of the time, that game has a very, very bad ending. Very bad ending.

100% of the time. And this time won't be different. I don't care how different this time is. Right. Even though it could be a year, 10 years, 50 years later. That's the trick, right? Again, the thing is we can do what we do, generate returns,

beat a position towards larger volatility. We don't have to, we're not betting on, oh, this is going to happen or not. We're betting in the general direction of all. So why take unnecessary risks where you're going to give up 10, 20 years, 30 years of returns? If you're invested in equities, when you can have the returns while being a long haul. Right. And it's not an either or, right? Like have your equities plus this

and rebalance it for you and enjoy life. Correct. And then one last thing out of your book, and I'm talking with Scott in your office about this and kind of the negative rates and kind of the under the radar issues that that can create um you know the

archa archa but ghosts i can never pronounce that bill huang supposedly was getting paid to take on more leverage like have any thoughts on that listen when interest rates are at zero you have many many free options available and very cheap free options. So very cheap means that, you know, you're not even paying a cost of carry on them. Leverage is an infinite leverage is almost available, right? He had multiple credit lines buying the same stock to the point where the company that he was buying was like,

wait a second, how did our stock get here? Let's issue some stock. Yeah, there were these packs, right? company that he was buying was like wait a second uh how did our stuff get here let's let's issue some stuff and he brought that so yeah there was max right they were borrowing there was a discount built in there so hedge funds were borrowing at zero basically correct facts and if there was a deal done they'd make 10 if there's no deal they get their money back yeah uh we've been peers like this we've always thought it's different and we've always gone back to, you know what? Reality does matter.

Reality wins 100% of the time, unfortunately. But in the meantime, there are little games that are played which are encouraged or they're kind of like side effects of what central banks are doing. They don't seem to mind very much.

Those things are more extreme than they were't seem to mind very much. Those things are more extreme than they were in 99 or in 07. And they're seemingly out of bullets, although we just said they'll build new bullets. According to if you read what the central bankers have written, they have plenty of stuff

to buy. I mean, they can, I think Bernanke said that he'll buy the garbage off the streets and put cash instead. I mean, at some stage, if you want to devalue a currency, you can really take it much further than they currently have. But with the level of debt that we're at,

you know, I would say it's the only course of action. Any other thoughts on Quest overall or the market or anything before we move on? Anything we didn't cover? Stay away from the crowd. Stay away from the crowd. It feels safe, but it's very, very unsafe today. You should write a book, The Non-Wisdom of Kraut. Cool. We'll do some of your favorites.

Favorite investing book. Covell, The French Following. He's had you on before I think too right favorite New York restaurant that's tough I'm gonna say Shibriyani downtown nice

favorite place to go outside of New York when you want to get out of the city Woodstock New York nice um favorite place to go outside of new york when you want to get out of the city uh woodstock new york nice the uh i got a friend who has a place up there i'll i'll connect you guys i went to school in upstate and disconnected in union college so i know the area a little bit uh your favorite quest white paper it's got to be the skew right the skew one yeah i guess it's the most uh used yeah we'll put that one in there and then finally your uh favorite star wars character that we ask everyone yesterday was may the 4th uh yoda i guess yoda i like it yeah the wise yoda yeah um great living many aspects of our lives are just like

a dream like and we take them for reality until we wake up until we wake up or do some meditation yeah and then i gotta ask you before we go on the gold discs back there is that your gold holdings or what what are those uh so those are that's an art piece but it kind of it's a little bit of recall of the gongs which i use for meditation uh so i'm really into like sound healing and stuff and so it's kind of uh so you hit the gong and it vibrates then you kind of focus in on that noise well it creates a sound which actually affects the way that you think so uh i don't know the theory but they say that we think in sounds and vibration and that vibration actually if uh shuts down your everyday thoughts and it's a very useful tool in helping you meditate so people who don't know how to

meditate or it kind of overwrites your thinking and uh lets you uh relax very very deeply you don't have it for in the office when someone comes up with a bad idea? We do have four or five of those in the office, actually. So that's why. Gong show. Yeah. All right, Nagal, this has been fun. Thanks so much.

Thanks, Jeff. Thanks so much. Yeah, hopefully things open back up and we'll see you next time I'm in New York. Thanks. Great. Talk to you soon. back up and we'll see you next time I'm in New York. Thanks. Great. Talk to you soon. We'll talk to you soon.

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