The Pursuit of Robustness in Systematic Macro Trading
QCM Thoughtpiece by Aref Karim, CEO & CIO, Raami Karim, Deputy CEO, January 2023
Major tsunamis have hit global markets in the past couple of years amid a pandemic loss of 6 million lives, the war in Ukraine, a major energy crisis, and soaring inflation. A $10 trillion global stimulus saved some economies. Central banks now walk a tight rope between rate hikes and that of tipping the world into a recession. Altogether, this may have been a perfect Black Swan. How does a robust investment strategy cope with this?
Robustness and complexity
More than ever, investors need their portfolios protected from market upheavals while being saved from the painful erosion of their wealth through inflation.
Robustness to us is a strategy’s ability to deal with market shocks while extracting performance from opportunities. It should generate returns in most economic cycles, and yet profit/protect the portfolio from unexpected market setbacks and systemic events. Often known as ‘crisis alpha’, the latter is an attribute that investors welcome. Examples of past shock events are the 1987 market crash, the 2008 financial crisis and the recent 2020 Covid pandemic. All these provided opportunities to generate ‘crisis alpha’.
QCM combines sound economic principles and scientific ideas with the art of intuitive thinking and creativity to develop proprietary investment models. It executes the model-based ideas through a systematic macro strategy. The challenge is to construct a set of holistic rules that are robust enough to navigate the portfolio through most situations. Such a strategy should be resilient and profit from most market conditions. At the same time, it should not use many moving parts. As the number of variables increase, a strategy tends to compound in complexity, and this can lead to a loss of robustness.
The universal principles of simplicity in strategy design are summed up in Van der Rohe’s dictum “less is more” or in Occam’s Razor: “…in explaining a thing, no more assumptions should be made than are necessary”.
Simplicity and Parsimony
Robustness in a systematic strategy comes with a degree of parsimony. To be frugal, however, is not to imply that models need be simple. Adding some complexity to a strategy may pick up additional alpha for investors but the art is to find an optimal mix. A robust process is muscle-building in approach, working with a few dominant input variables affecting asset prices. The variables need to explain the rise or fall in risk premium, the excess return over a risk-free asset. Starting simple and introducing parts frugally that add value, is a better way towards robustness.
With four years behind our upgraded models, QCM believes that investors now have access to the most robust iteration of its systematic macro strategy.
Differing views on robustness
Robustness has a context in the passage of time. It is generally thought that slow systems that consider longer time horizons are more robust. Staying above the noise level, they usually let the model ride a macro trade without getting knocked around by market aberrations. This is more in sync with staying in line with fundamental momentum. But drawdowns can increase if positions are not adjusted regularly.
In contrast to the above, short to medium term models target shorter holding periods and hence the frequency of profitability needs to be relatively high as the profit margins are typically lower in a short holding period. Both the above systems, carrying different profiles, can be robust. Hence to the successful manager the period is a matter of choice.
QCM runs a robust strategy that is not boxed into fixed time horizon. Each portfolio position morphs into a trade with no discrete boundaries in time. We buy or sell into relative strength or weakness and transcend the concept of fixed time in the strategy. QCM sees greater value in developing an investment strategy that uses few variables which explain most market phenomena. This leads to a preference for a longer-term trading posture for our core macro component which looks for major imbalances in markets. We see less need for frequent updates, avoiding at the same time the risk of over optimisation. At the same time, we also place considerable value in short or medium-term orthogonal tools that separately capture the more immediate sentiment in markets. In aggregate a position seamlessly expands or contracts in exposure and changes direction by a combination of all the orthogonal forces encapsulated within one robust strategy.
Changing patterns of markets
When scaled over time, a market evolution is like that of human. The world adapts to new information, sometimes fast, sometimes slow. We see fast reaction over a shorter time frame when examining fashion or in our tastes, while the effects of climate change for example is a much slower reactionary process. We respond to both, the first in a more immediate way and the second in a slower strategic manner through a change in our thought process over time. The latter needs more convincing.
Financial markets are similar, under or over-reacting, either quickly or slowly to changes. The process is also subject to random shocks that shift data into unknown territory at an unknown time. New events or developments push market participants to identify new sources of risk and return, replacing or adding to strengthen old ones. Markets also have a way of changing character; much like the mythological water-serpent, Hydra, which grew two heads for each that was decapitated.
A robust model should not assume that normalcy will return when markets show a change of pattern. Tectonic shifts can permanently change the behaviour of a market, or its underlying economic systems. We find that a reduced-variable approach, when successfully applied, deals better with more long-lasting changes in market conditions.
Relating Robustness to QCM
QCM is proud of its long history and its uninterrupted 27-year track record. It speaks abundantly of the company’s longevity, robustness and a firm commitment of its team and stakeholders.
In this long journey, QCM has navigated compellingly through some challenging terrain as well as normal economic cycles. Amid the worst global crisis since the Great Depression, when hell broke loose, QCM had its best year in performance in 2008. The monumental multi-year liquidity injection from central banks stabilised the economies in subsequent years. The after-effects of the devastating credit crisis however cascaded through the financial system and took its toll on our own strategies and many in the industry.
The years that followed took QCM through a challenging drawdown while a ‘new’ paradigm emerged. It introduced the power, swiftness, and readiness of Central Banks to intervene in the markets to artificially manipulate volatility (QE). This led us to embark on a three-year research deep-dive into our strategies. Our approach needed more convincing that the QE action was not a policy of short-term monetary easing but a multi-year pursuit to stimulate growth and bring back stability. It was only once we were convinced, that we implemented major model upgrades to make our strategy sharper, robust and more befitting for this new norm. These were implemented in November 2018 in their first form.
Final Thoughts
QCM believes the pursuit of robustness has no end. Like a giant ship at sea, a robust strategy needs to move the vessel slow and with stability. We achieve this by decades of market experience, observing their evolution, cognisant of changing geopolitics, climate changes, and other natural phenomena. Today, markets reverse course while central banks drain liquidity in the face of rampant inflation. Managers and their models will once again be tested as multiple asset classes start to twist and turn in various directions.
The process of innovation continues at QCM while the firm actively explores, reviews, and conducts research for new investment ideas, a never-ending pursuit. The last four years have witnessed major market upheavals, but the 2018-upgraded QCM strategy, has robustly handled these shocks to generate attractive risk-adjusted returns for its investors.
QCM partners with investors to run a systematic macro strategy and when designing models, robustness takes centre-stage in its foundational philosophy.