Form an orderly QIS: hedge funds spur quant products to new heights

Banks’ quantitative investment strategies are showing up in the strangest of places: the portfolios of the hedge funds that inspired QIS in the first place.

Interest from hedge funds has propelled a 20% increase in the QIS revenues of the most active dealers over the past 12 months and lifted total estimated notional assets under management to a record $350 billion.

“What’s new is the number and range of hedge funds looking at and trading QIS,” says Guillaume Arnaud, global head of QIS at Societe Generale. “We used to trade with a limited number of accounts pre-Covid, but now there are many more players. In the past two years, it’s been the fastest-growing segment.”

Other dealers report a similar trend. Hedge funds have been the fastest growing client segment for UBS’s QIS business over the past 12 months and account for around half of all inflows into Citi’s QIS platform. A third dealer, which declined to be named, has quadrupled the number of hedge fund clients it trades QIS with since the start of the year.

The shift required a leap of faith from both sides.

Dealers once shielded the nuts and bolts of their most lucrative strategies from hedge funds for fear of frontrunning. “Now, it’s a different story,” says Arnaud Jobert, co-head of JP Morgan’s index strategy business. The bank has discussed its QIS products with dozens of hedge funds in recent months and even presented some of its strategies at a roundtable event with hedge fund clients in New York.

What’s new is the number and range of hedge funds looking at and trading QIS... In the past two years, it’s been the fastest-growing segment

Guillaume Arnaud, Societe Generale

“I would never have thought I’d be talking about high conviction QIS strategies with hedge fund clients,” says Jobert. “But we’re doing that alongside our senior risk takers, who are giving high conviction trades in the equity volatility and delta one space.”

Hedge funds, which once dismissed QIS as cheap knock-offs of their own strategies, have also changed their tune. The biggest buyers have been the funds’ “pod shops”, which trade multiple strategies and are typically organised as collections of autonomous trading teams.

“Hedge funds haven’t historically been among the ‘traditional’ users of QIS, but it’s a client segment that we’re starting to see become more and more active,” says Ben Barr, Europe, Middle East and Africa head of equity QIS structuring at Bank of America (BofA). “If you’re a portfolio manager with finite resources, it can be more efficient to outsource some of the more resource-intensive trading strategies to a bank, rather than trying to build something similar internally.”

QIS products enable pod shops’ portfolio managers to diversify quickly if their existing strategies get squeezed. That was the case in late 2022, when pods piled into commodity strategies as a hedge against rising inflation, which decimated the returns of equity and fixed-income strategies.

“All of these pods have limited capital and resources,” says Jérôme Brochard, global head of QIS structuring at Nomura. “If at some stage you want to get exposure to something decorrelated and get some leverage on it, QIS is a very good way to do that.”

Hedge fund investment in QIS has been growing from a small base and represents less than 5% of notional assets at some of the largest dealers. However, some think the recent shift could be the start of something big, and perhaps revolutionary. 

“It’s a trend that will continue with both delta one investments and options,” says Julien Lascar, global head of equity sales at BNP Paribas. “Looking even further, if you bring a lot of those very smart guys to learn more about QIS and the advantage of QIS implementation, what we will see next is banks and hedge funds working together to market new strategies.”

In pod we trust

Banks’ QIS businesses have been the unlikely beneficiaries of the rise of pod shops, which have more than doubled their assets under management in the past five years to around $340 billion, according to data from analytics firm Pivotal Path.

Pod shops typically comprise teams of one to five traders who specialise in a particular strategy or asset class. Individual pods might focus on fixed-income carry or equity volatility and have little to fall back on if those strategies fail to perform.

“What they need to cover their downside is something countercyclical, like trend-following or long defensive options,” says Anthony Morris, global head of quantitative strategies at Nomura.

It’s not only at the pod level that QIS is providing a safety net. Although the trading teams will employ different and often uncorrelated strategies, pod shops are vulnerable to “re-correlation risk” if a stress event causes asset prices to drop in tandem. Some have therefore started to use QIS to hedge re-correlation risk on a firmwide basis.

I would never have thought I’d be talking about high conviction QIS strategies with hedge fund clients

Arnaud Jobert, JP Morgan

“There is another layer on top of these multi-pod hedge funds where a few people have the mandate to monitor aggregated exposures, hedge excessive risks and take some views,” says Nomura’s Brochard. “QIS strategies are part of their toolkit for this. It can be a firm already trading QIS at pod level, but it’s almost two different clients.”

Pod shops began testing the QIS waters in late 2022, when commodity strategies outperformed against a backdrop of soaring inflation.

“If you have a hedge fund specialised in fixed income, doing all sorts of trades monetising carry, and they see a really good carry trade in commodities – what do they do?” asks Sandrine Ungari, head of cross-asset quantitative research at Societe Generale. “Opening a pod means having a trader, a portfolio manager, building infrastructure and creating defences. Alternatively, they just tactically invest in a bank product that does the strategy for them.”

This was mostly done via options on baskets of indexes. By packaging QIS strategies such as commodity carry, trend and value into vol target indexes – similar to the way fixed index annuities are created – dealers were able to provide hedge funds with access to highly convex exposures with high Sharpe ratios and low premiums.

“Individual pods can be pretty limited in the tools they can use, but options are generally part of the toolbox,” says BNP Paribas’s Lascar. “Buying an option on a low vol basket of indexes doesn’t use a lot of capital, doesn’t bring a lot of risk and gives some diversification.”

BNP Paribas sold €1.5 billion notional of options on commodity strategies to hedge fund clients across Asia, Europe and the US between November 2022 and March 2023. The demand has accelerated since then, with an another €1.5 billion of notional written in January alone.

With vol targets of between 2% and 4%, a hedge fund might pay just 1% or 2% upfront for one- to two-year options that provide exposure to a combination of QIS strategies with more upside than downside.

“If you put enough commodity strategies together, they tend to be quite uncorrelated with one another,” says Lascar. “Even though you put a low level of vol control on the back end, you can still have a steep convexity on the option.”

A portfolio manager at one multi-strategy hedge fund says options on QIS have been a game-changer for pod shops, giving them a “cheap, efficient way” to diversify into new asset classes.

What’s the use case?

A trend that began with commodities has now spread to a host of asset classes and strategies.

“We’ve seen a lot of use cases for commodity QIS with fixed-income pods, but we’ve also seen a lot of use cases for equity vol carry with macro pods,” says JP Morgan’s Jobert. “It’s the cheap alternative for hedge funds to quickly implement something with QIS as opposed to hiring specific portfolio managers. It’s definitely a big driver year-on-year.”

BNP Paribas is also offering options on equity vol strategies to its core hedge fund clients.

Among the other strategies popular with hedge funds are intraday equity momentum and forward rates vol, both of which require extensive trading infrastructure to execute.

“If you think about a strategy where you’re trading hundreds of different options and delta hedging multiple times per day, some hedge fund pods may prefer to outsource this operational burden to the bank, meaning they can get their “beta” exposure to certain risk premia via QIS and instead focus on alternative sources of alpha,” says Youssef Brahimi, global head of equity structuring at BofA. 

If you bring a lot of those very smart guys to learn more about QIS and the advantage of QIS implementation, what we will see next is banks and hedge funds working together to market new strategies

Julien Lascar, BNP Paribas

Alexandre Isaaz, BofA’s head of equity derivatives sales and structuring for Europe, the Middle East and Africa, says the bank has also seen long/short equity managers using QIS to replace cumbersome options-based hedging strategies.

“Rather than opportunistically buying put options to protect the portfolio, which can be a distraction and also relatively expensive, portfolio managers can use QIS to hedge their market beta and then concentrate on what they do best, which is taking a fundamental view on single stocks,” hesays.

Spyros Mesomeris, global head of structuring at UBS, says all manner of hedge funds beyond pod shops could end up using QIS to hedge tail risks.

“What hedge funds are coming to us for is specific use cases – maybe a more defensive, tail hedge-type portfolio,” he says. “If you’re a tail risk hedge fund, you do that for yourself. But if you are not, there might be value in sourcing liquid tail portfolios at a reasonable cost, which you can overlay to your own fund just in case something goes wrong in the market. If what you’re running is more aggressive strategies, you can put some premium aside to spend on something which is clearly complementary.”

Limits on the hedges

When it comes to options on QIS, there are limitations.

According to the portfolio manager, many dealers only offer options on a limited range of indexes. Some prefer not to write options on strategies with embedded options exposures. 

Dealers concede that it is a delicate balance for both buyers and sellers. Options-based strategies typically offer better carry than more liquid futures-based alternatives. However, trading in and out of those strategies can be more expensive owing to the wider bid/offer spreads. This means dealers’ gamma hedging of these exposures is also more expensive – a cost reflected in a higher premium when writing options on those strategies.

“People tend to put a small proportion of options strategies in the basket because they still want a good carry in a number of strategies,” says Societe Generale’s Arnaud. “But, at the same time, they want option pricing that’s going to be pretty aggressive and have a low premium.”

He adds that clients often limit the proportion of options-based strategies in these baskets to around 10-20% to avoid hefty options premiums.

Although dealers are embracing the trend, they do not envisage blanket access to the full gamut of QIS for all investor types.

When banks began to package their equity vol carry strategies into systematic indexes more than a decade ago, many were keen to keep the methodology away from specialist vol arbitrage funds, fearing the funds might try to frontrun the strategies.

“There’s probably a bit of concern around trading strategies that are sensitive in terms of signalling or parameter dislocation,” says Jobert.

Although some dealers are offering their proprietary vol strategies to vol arbitrage funds and specialist vol pods, others are exploring different routes.

JP Morgan says increased synergies between its Nexus platform and the bank’s own QIS intellectual property is already providing outsourcing opportunities to vol pod clients.  

“We’re seeing more clients ask for execution to be outsourced, which is very much leveraging on the best of both worlds: Nexus, which is a well-established platform, and strategic indexes, which is a well-established brand when it comes to volatility,” says Jobert.

He adds that the bank has expanded its vol business to include an array of building blocks offering delta hedging capabilities across multiple markets: “It means we can still be very relevant to vol pods out there, where they have an execution and outsourcing angle.”

Editing by Kris Devasabai and Daniel Blackburn