Trend following hedge fund Quest Partners’ tail risk strategy soars amid volatility surge

Nigol Koulijian, Quest Partners

Quest Partners, a New York-based systematic CTA, has carved out a strong track record over the past two decades, tapping into market opportunities arising out of volatility swings and increased tail risk in assets using a nimble short-term approach that enables it to switch in and out of positions quickly.

The firm’s flagship fund, the AlphaQuest Original Program (AQO), today manages around USD1.5 billion in assets, boasting an annualised return since inception of nearly 11 per cent. 

Now, as uncertainty continues to loom large over markets following years of suppressed volatility, the strategy’s focus on tail-risk opportunities appears to be strengthening its advance as other hedge fund strategies stumble.

Its short-term, momentum-based approach, comprising positions typically lasting around eight days, has proven particularly successful during this year’s market carnage. As fears over the spread of the Covid-19 pandemic ripped through global markets last month, sending stock markets plummeting and volatility levels surging, AlphaQuest notched up a stellar Q1 return of some 17.5 per cent, and has continued to advance during April.

Hedge funds have seen considerable dispersion in terms of performance metrics in recent weeks. Strategies that managed to capture the spike in volatility patterns – such as managed futures funds and certain macro vehicles - enjoyed stellar gains. But most long/short stock-pickers slumped as the long bull run which had powered performance in recent years went into sharp reversal as the coronavirus outbreak spread.

“Due to the volatility expansion in March, our positioning and portfolio construction allowed us to move much faster and more aggressively than other market participants and trade in the direction of the move,” Nigol Koulajian, Quest Partners’ founder and CIO, tells Hedgeweek of the strategy’s Q1 performance.

“We enter trends and exit trends much faster than typical CTAs – between five and six times more often than a typical trend follower. We will exit trades when we see the volatility is unlikely to increase much, or when the potential for volatility is no longer there, even though the trend may still be active.”

A skewed market

This emphasis on volatility, and its complex and dynamic relationship with tail risk, forms the core of Quest Partners’ approach to investing. The strategy typically trades in the market direction where volatility is likely to increase, tending towards long tail risk positions.

As a result, it is often far less exposed to trends that are risk-on, since those often have negative tail risk exposure. As the S&P 500 continued to record new highs just prior to the market collapse, AQO was positioned far less bullish due to the S&P’s increased potential for a left-tail event allowing it to seize on March’s dramatic market reversal.

Specifically, the fund was positioned long on fixed income and the Japanese yen and short oil, where much of its gains were made.

“Typical trend followers and CTAs were ending up being more or less risk-on in an environment where equities were having strong returns,” Koulajian says of the prevailing market environment of the past few years. 

“If investors are shorting tail risk, they are looking at things which basically have low volatility and considering them to be low risk. But that has made the market more skewed than ever, and it’s made tail risk extremely cheap relative to what it should be.

“What we try to do is find places in the market where tail risk is cheap as a result of this unintentional but highly-related shorting of tail risk, at almost any price, by most of the asset management industry.” 

Opportunities and challenges

This, Koulijian says, is offering up an “amazing opportunity” for Quest Partners to position itself long tail risk, and generate considerable alpha by trading an assortment of Delta-One instruments, such as futures and forwards where other hedge funds have lodged short bets.

“We have the same amount of alpha as typical risk-on funds such as converts, stat-arb, event driven and so on. We also have the same information ratio to the S&P 500 as them. But we’re doing it with the tail risk exposure of a short hedge fund. With us, you’re effectively investing with a short-seller but you’re getting the alpha of a risk-on strategy at the same time.”

This approach has helped the fund frequently generate double-digit annual gains since launching in 1999, with only five down years during that period. Since inception, AQO has made around 10 per cent more annual return relative to the S&P 500 and a long-VIX strategy, with similar hedging potential.

“Not only for March, but for the last 21 years we’ve been able to deliver a 50 per cent short on the S&P plus 10.4 per cent on top, on average. With us you're getting 1.38 times the CTA index, plus 7 per cent a year,” he says.

Reflecting on the track record, he continues: “It’s not simply a question of just offering tail protection. It’s about providing returns that are very valuable as an addition to a portfolio of equities and fixed income. Whereas most market participants are trying to create a return stream that’s dependent on equities and fixed income, we are trying to provide a return stream which is incrementally valuable.”

A perennial challenge for this type of short-term trend strategy is liquidity, and the ability to constantly readjust market exposures quickly intra-day.

“It’s not enough to have a liquid market – we need liquid markets all the time. We need to be able to flip our positions and increase or decrease the risk very quickly in the direction of the market, particularly if the vol is not reliable,” he explains.

“On the upside, the opportunity set is substantially higher. So once the vol increases typically we have many more inefficiencies around vol compressions, and you’re typically able to generate a more steady stream of returns and alpha. That’s the balance: how much liquidity there is in the market versus the opportunity set.”

Hidden volatility 

During the height of the Global Financial Crisis, the strategy notched up a remarkable 55 per cent return, and now Koulajian believes that the current turbulent environment offers equally attractive opportunities – in part due to the lasting legacy of decisions taken during the 2008 maelstrom.

Indeed, he suggests the suppression of volatility as a result of central bank policies over the past decade has made the market today “much more dangerous” than in 2008. 

“The level of leverage in the market is much higher than it used to be. Because volatility has been so compressed for so long, because of the monetary policy of central banks, people have levered themselves higher. We have a very levered economy; corporations borrowed money and bought back their stock. 

“Now the market has become much more vulnerable to monetary policy than in 2008,” he observes. “The tail is wagging the dog much more than the other way around, and any type of correction in the market becomes very influential in the economy.” 

As a result, market participants are now using what Koulijian believes is a “very abnormal volatility profile” for measuring market risk, and in the absence of any major correction in the last 12 years, investors have tended to view markets through the lens of sustained lower volatility – and have been largely comfortable with their returns.

“What we say is that volatility is not the relevant risk in the market today. Vol has been intentionally suppressed by central banks, so if you are measuring risk through volatility then you are going to underestimate risk completely, and potentially mis-price assets,” he says.

“Investors should be really careful about chasing high Sharpe ratios or investing in any type of hedge fund strategy without evaluating tail risk. Tail risk is a by-product of hidden volatility or hidden correlation and leverage.

“In this market environment in particular, it’s very important for investors to evaluate those risks effectively before they invest in hedge funds. Otherwise they are going to have a lot of surprises of a magnitude which is going to be very unexpected.”

Looking ahead, Koulijian believes last month’s market disruptions are potentially only the beginning of a deeper protracted crisis. 

“The current crisis is only a month old – we really haven’t had much of an opportunity for the equalisation or repricing of risk to actually manifest itself in the market,” he says. “But the opportunity for our strategy is tremendous going forward.”