AREF KARIM HAS ALWAYS BEEN DRAWN TO ART that’s clean and simple: the paintings of Mark Rothko, the poetry of Pablo Neruda, and operas like Giacomo Puccini’s La Boh•me are among his favorites. He lives in a Zen-inspired home with sleek, clean lines in Weybridge, Surrey — a semirural hamlet near London. And his Quality Capital Management, a commodity-trading advisor, reflects the same principles of artful efficiency. [kasim] Martin Beddall for Barron’s Since instituting a new investment system in 2005, Karim’s gains have more than doubled — to 26% a year. His flagship hedge fund, the Global Diversified Program, with $600 million in assets, invests long and short across 80 financial and commodity markets. Although it has struggled this year, the fund’s average annual return since its founding in 1995 through June of 2009 is 15.82% — with just one losing year. Karim’s tactics seek to profit consistently, regardless of what’s happening to stocks, interest rates, currencies, or commodities. The program is managed through a trading system he refers to as the Advanced Resource Allocator (or ARA), which continuously rebalances short-term tactical moves aimed at gathering quick profits or acting as hedges against existing positions, and longer-term trend plays that look to make bigger gains. KARIM’S ALLOCATIONS ARE BASED on risk, or what he defines as “short-term downside volatility.” This informs his asset allocation, which in June was spread across 11 different markets. His major macro exposure was in long-term bonds (14%), followed by metals (12%) and energy (11%), along with 9% each allotted to medium-term notes, short-term sovereign rates in major markets around the world, and stock indexes. Large portions of these investments were hedged by short positions generated from his short-term model. This constant fine-tuning is what enables Karim to limit risk while seeking consistent gains. The weighting of asset classes and markets is constantly adjusted as the firm’s ARA interprets market trends to limit risk. During the first week in January, for example, the fund’s position in long interest rates fluctuated from below 6% up to about 16%, and currency exposure oscillated between 13% and 22%. The highest allocation at that time was energy, which peaked at 26%. How ARA constantly recalibrates investments was seen in its long-term short on oil. In early March, after oil had bottomed the previous month, the program started countering the position by overlaying a short-term long exposure to the commodity. This temporarily produced a net-long position. ARA expanded the net-long position until oil hit a short-term peak in early April. When selling again started to push down crude-oil prices, ARA shifted its stance to neutral, and then to a small net-short position. THE RESULTS OF KARIM’S PROGRAM ranked him fifth in Barron’s recent survey of the top 100 hedge funds ["Acing a Stress Test," May 11]. Last year, the fund soared by more than 59%, and his three-year annualized returns through June 2009 were 19.44%. This handily topped the performance of both BarclayHedge’s hedge-fund index, which eked out a gain of 0.73%, and the Standard & Poor’s 500, which was down 8.22%, over the same three-calendar-year period. “Our sentiments toward the market conditions are agnostic,” explains the 56-year-old Karim, a chartered accountant who worked in the alternative-investment department of the world’s biggest sovereign wealth fund, the Abu Dhabi Investment Authority, from 1982 until 1995. “The key to our performance is an investment program that searches for upside volatility while limiting exposure to markets that are trendless or fluctuating lower.” And while his aim is always to be in the markets, Karim has no problem building up cash when opportunities are not clear. As market uncertainty reached its peak in March, generating confusing buy-and-sell signals, his cash position hit 75%. As markets settled down and signal distortions decreased, he lowered his cash to 60%. Normally, it’s around 25%, always enabling him to respond to opportunities. Karim credits his performance to a team of 21 professionals and the development of strong systems, including ARA. “Before we changed our investment approach,” he explains, “our previous systematic trend-following program was not making the most of upside volatility, because it employed too many filters, trying to respond to signals in all market conditions. This restricted investments and reduced profit potential.” In contrast, ARA is more opportunistic, continuing to effectively manage risk by basing allocation on that primary concern, which has produced remarkable results. Using the original investment program between the fund’s inception in December 1995 through January 2005, annualized returns were a respectable 11.4%. Since the installation of ARA in February 2005 through June 2009, annualized returns have soared to 25.9%. Last October, short-term rates were already trending lower, when the world confronted a massive liquidity crisis as systemic turmoil expanded and equity markets started to collapse. Using a variety of interest-rate contracts, including euro-dollar futures — a three-month interest-rate contract that tracks U.S. interbank rates of equivalent maturities — the program increased a long position established in June 2007 when short-term U.S. interbank rates were at 5.4%. In September 2008, it upped its stake when rates fell to 3.6%. By early November, when rates hit 2.1%, ARA started peeling back exposure, as it saw a deceleration in the downward trend. At about the same time, ARA recognized a flight to safe currencies. It programmed long dollar positions against the world’s major currencies through various positions, including U.S. dollar-index futures contracts — baskets of currencies versus the U.S. dollar — which in early September 2008 were indexed at 78.4. By mid-October, ARA had started to reduce this long position — when the index hit 90, as exchange-rate volatility rose to extreme levels. This move helped the fund avoid the subsequent selloff of the greenback. By the end of March 2009, after commodity prices collapsed, the program established a long position in many grains, including soybeans, as it saw prices starting to rebound off their lows. At the time, soybeans were at $6.78 per bushel. The rally continued through the end of May, as soybeans hit $10.30. When the program detected signs of the rally breaking down, it started downsizing the fund’s exposure. THE SYSTEM DOESN’T ALWAYS work. The primary reason, Karim explains, is unusually swift market changes, when ARA is unable to detect better investments than the ones the fund is already in. But he argues that such limits also contribute to the system’s resilience and robustness over the long run. A bad bet came earlier this year with 10-year U.S Treasury bonds. The fund had profited from a long position as deflationary worries at the end of ’08 sent investors rushing to lock in rates, sending bond prices higher. By December, when he increased his long exposure, Treasury-bond prices were at 125. However, the huge build-up in government spending to finance big bailouts and stimulus packages transformed fears of deflation into inflation worries. By early February, the bond price had dropped to 118. “The collapse occurred so fast that our system couldn’t respond; it was unable to redirect resources to a superior position,” Karim says. The fund has not performed well during the first half of this year, down 14% through June. The key reason: extreme volatility across virtually all markets, which were ultimately trendless. Karim did profit in energy and commodities. But he got hit harder by his financial exposure. With many suggesting that the worst of economic and investor fears are over, it is unlikely that we will see a repeat of the eccentric market behavior of the past six months. And Karim feels today’s sidewise movement of markets bode well. “Periods of such indecision usually are followed by breakouts,” he explains. And with more than half the fund’s assets currently in cash, Karim is well prepared to exploit the next trend, regardless of direction.
