(Bloomberg Markets) -- Nigol Koulajian, founder of New York-based Quest Partners, has beaten rival hedge fund managers over two decades by refusing to follow them into crowded trades. Since the financial crisis, commodity-trading advisers (CTAs), which specialize in trading futures or options, have piled into long-term bullish bets, riding the market up in search of steady gains. That’s left them vulnerable to big losses when volatility strikes—the very moments when Koulajian’s $1.35 billion quant firm cleans up. His AlphaQuest flagship fund has posted an annualized gain of 9.7 percent since its inception in 1999, almost three times that of the BarclayHedge BTOP 50 managed futures index and nearly 4 percentage points more than the S&P 500, according to a document seen by Bloomberg. Here Koulajian, who turns 52 in June, talks about style drift, momentum, and how surviving a civil war in Lebanon shaped the way he trades.
When others zig, you zag. Are you by nature contrarian?
Not by nature. I grew up in an environment which is different than most people on Wall Street. For me, the world is much less stable than it appears to a typical asset manager, because I grew up in a war zone. The tail event, the low-probability event that can have a massive impact, has much more importance to me.
You were raised in Lebanon during the civil war in the 1970s and ’80s. How dangerous was it?
I have friends and family who died. I’ve been shot at. I was next to a car bomb. I’ve walked on minefields, unknowingly. I’ve been held at gunpoint a few times. I’m still here. [Laughs.]
At 16 you fled Lebanon and came to the U.S. You got an engineering degree at Notre Dame. How does an engineer approach markets differently than, say, a mathematician?
An engineer is much more aware of the potential impact of errors. If there’s a small chance the market will be down 50 percent, I would take that 1 percent scenario into account much more than a mathematician. Our strategy is designed around the fact that the mind can’t handle low-probability events very well.
At Columbia, where you got your MBA in 1992, what did your professors think of your fascination with technical trading?
They laughed and said fundamentals are much more relevant. I had a business plan ready to go, and I had to follow the professors into the bathroom to have the time to speak to them about my models.
What is your strategy today?
Where the typical quant manager looks for long-momentum trends with low volatility, we look for moves where the market is most likely to have an expansion in volatility and then benefit from that.
How common is your strategy?
Not common at all. Very few managers trade in the time frame we do, seven to eight days on average. It’s much more difficult to trade short term. There are more transaction costs.
Why bet on spikes in volatility?
Since tail-risk events that cause volatility to rise aren’t priced into assets by most managers, that’s our edge. We can buy these assets—similar to long-term out-of-the-money options—very cheaply. When the surprise strikes, the typical manager will have to react very quickly and will dramatically affect the market. We hope to benefit from that. In today’s world, we’re more likely to go long commodities than short commodities.
So you’re betting that commodities prices will rise?
No. We’re betting if they rise, it will be unpleasant for most managers. The market is effectively short, and they’ll have to cover their shorts very quickly. When you are short commodities, you are getting paid carry. In energy it’s 15 or 20 percent a year. Our models are saying there’s too much of that going on, and anytime the market goes up it forces these liquidations, and you want to take advantage of that.
You’ve taken losses so far this year through April. What happened?
In general, we make money when the S&P goes down and when volatility is increasing. And this year, both of those factors have worked against us. When we lose money, we tend to lose it very consistently and then make it very fast, exactly the opposite of a typical hedge fund.
You’re critical of style drift—managers who flock into long wagers and give up on shorts. What caused that drift?
When central banks became very accommodative in providing liquidity a decade ago, the market cycle became much more long-term. A lot of hedge funds adapted. They became more long-term and biased toward long trades. They’re likely to benefit much more in this market. But they’re also very likely to get hurt substantially should the regime shift.
Have CTAs betrayed their mandate to provide downside protection?
They definitely have betrayed their original philosophy. Investors still don’t understand the style drift that their managers have engaged in. In some cases it’s likely the managers themselves don’t understand the style drift. They’re following what’s worked, the strategies that have the best returns. As a result, unknowingly, they’re becoming much more risk-on. And because of machine learning, these biases are not as visible as they used to be.
Where is the crowding today?
Too much money has flowed into factor strategies like momentum, value, and low volatility. And now they’re providing very consistent negative returns, although the market environment hasn’t changed. So being contrarian means evaluating how crowded a strategy is and going short something that’s always made money just because people believe in it. It also means not believing academia no matter how many research papers have been written. It’s more about evaluating what the supply and demand is for the factors.
You have a meditation room in your offices. Does anyone use it?
Oh, yeah. We’re exposed to so much information. Our nervous system wasn’t designed to handle this. Stress has an effect on your objectivity. When you’re under stress you act with 100 percent confidence—this way or that way—but you might be wrong. Meditation helps you reevaluate the world and question your thoughts and see the world without all your memory and fears.
Bielski is a senior editor on the investing team at Bloomberg News in New York.
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