Best of TTU – The Problems with Smart Beta & is Filtering the Holy Grail?

Kathryn Kaminski and I had the opportunity to sit down with Nigol Koulajian, the founder of Quest Partners, in which he shared his deep insights in many areas of trading. During our conversation, there were a few short segments that I particularly enjoyed and I would love to share them with you here. Below you can learn about Nigols take on the problems with Smart Beta, and also his explanation of Filtering being ͞the Holy Grail. This interview was packed with insight and wisdom so if you would like to hear the full episode then you can do so by clicking here (#101) and also here (#102).
The problems with Smart Beta
"Nigol: So, the short-term index is flat since inception, or negative or actually down since inception. So yes, "challenging" is, as I said, you’re being extremely gentle.
So, why are short-term managers still getting allocation? This is because of diversification, but also because of convexity. If you’re long a put on the market and it’s going to cost you ten percent a year, fifteen percent a year, twenty percent a year, you can get the same protection for five percent a year negative.  Investors who are pricing these things accurately will see a great investment.


"...what’s critical is that the short-term space is much more easily crowded"

So, lucky for us, we’ve been able to provide substantial alpha relative to the CTA indices, whether short-term or long-term. So, in the short-term space what’s critical is that the short-term space is much more easily crowded. When you’re trading short-term, you’re typically trading more stops and trading on stops intraday rather than VWAPing (Volume Weighted Average Price) or trading market on open, market on close.
So, you’re very sensitive to spikes in the market, up or down, and you’re getting whipsawed much more if you have short-term noise. So, what’s critical to do then is to have the right filtering techniques.
Of course, you want to buy cheap convexity, and you want to sell expensive convexity, realized in the markets. One way to do this is, if everybody is trading a ten-day channel breakout, you want to short ten-day channel breakout.
If you look at the short-term CTA index, you can have seventy percent correlation to it by trading ten-day channel breakouts. I know short-term CTAs are much more short-term than that, but ten-day channel breakout I think has seventy or eighty percent correlation.
So, this is kind of like the smart beta version of the short-term CTA index. You want to be shorting that and going long momentum around it. So, if everybody wants to buy the S&P, nobody wants to buy stock number five hundred and one, short the S&P and go long small cap. It’s typical arbitrage of equity long / short.

The same thing applies in the CTA space. You want to short smart beta and go long everything around it. In the short-term space, in particular, where you’re highly affected by the liquidity of the markets this becomes very, very critical. So, there are ways to trade mean reversion where it’s kind of like the “lazy man’s trading,” where you want to find the positive convexity around it, the same as I explained with the S&P.
Niels: Just curious, maybe on a slightly different tack. You bring up the words “smart beta.”Of course in our industry, and in particularly the trend following space, over the years it has been... Certain firms promote trend following as being a very easy risk premia to replicate, so they sell their products very cheaply. Yet, I have not really seen that these products have outperformed the true veterans in that particular strategy.
I’m just curious, but the smart beta products, some of them, have raised billions of dollars because people look at the fees and say, “Oh yeah, it’s easy so we shouldn’t pay so much for it.” So when you say you should short beta and do everything around it, what should you then do?