Following up on our most recent article, “Infinity Q: Too Much Alpha,” Infinity Q also managed a hedge fund product, Infinity Q Volatility Alpha, which exclusively employed volatility strategies. This fund, which held $760 million per its March 31^{st} 2020 regulatory filings, is now being liquidated as well. We have compared the performance of these two funds, in the chart below, over the common time interval from September 2014 through January 2021. The Volatility Alpha hedge fund returned an annualized 16.8% which is more than three times the return of the Diversified Alpha mutual fund, at 5.3%, over the same period (albeit before the March 2021 adjustment).

Although the difference in returns is striking, it’s not uncommon for a hedge fund to perform better than its mutual fund version given all the investment, trading and leverage constraints that are imposed on a ‘40-act registered vehicle.

The financial media has focused on both funds’ unusual results during the COVID-19 pandemic. In June 2020, following their reporting on some of the prominent volatility-trading hedge fund blow ups of the Corona Crash (e.g., Allianz Structured Alpha, Malachite, Parplus Partners, Ronin Capital) and successes (e.g., Universa, Capstone), *Institutional Investor* got a tip that Infinity Q’s Volatility Alpha LP hedge fund “had a substantial first quarter drawdown”. Velissaris, Infinity Q’s CIO, responded to *II*’s inquiries that the Volatility Alpha hedge fund had a positive 5.6% Q1 2020 return. The Wall Street Journal, in a recent article, also focused its investigation on potential issues with the fund’s derivatives’ valuations related to the first quarter of 2020.

Our analysis of the Diversified Alpha fund found no apparent issues with its performance during COVID-19. Below we show both funds’ first quarter 2020 performance and compare it with that of the S&P500 Index, the S&P 500 VIX Mid-Term Futures Index, and the Bloomberg Commodity Index. In our research, we noted that Diversified Alpha’s Q1 2020 performance was primarily driven by these Commodity (short exposure) and VIX indices (long exposure). The mutual fund returned 8.9% vs. 5.6% for the hedge fund, the VIX Mid-term index returned 85.5%, and the S&P 500 Index and Commodities index lost 19.6% and 23.3% respectively. Unlike most of their peers who suffered during the crisis, both funds employed a “long volatility” strategy which is designed to protect during a market downturn. Our model indicated that the fund’s negative commodity exposure explained why its COVID-19 performance was even higher than that of the volatility-focused hedge fund.

It is not uncommon for a multi-strategy fund to use some of its successful “pure strategies” as sleeves in a diversified vehicle. Following this logic, in our attempt to explain the $500 million performance gap,[1] we decided to use Infinity Q’s Volatility Alpha fund as a factor in our style analysis of Diversified Alpha, replacing the volatility index used in our previous study.

Shown below is the historical factor exposure for the Diversified Alpha fund when the VIX Mid-term volatility factor is replaced with the Volatility Alpha fund as a factor. You can see that the style is almost identical to the factor exposures in our previous paper. The Diversified Alpha fund is similarly consistently long the Volatility Alpha fund as it was with the VIX Mid-term factor. The short positions in equity value, term spread, commodities, and gold closely resemble the factor exposures of our original study that used the S&P VIX Mid-term Futures index as the volatility factor.

What becomes clear when plotting the fund’s returns in comparison to its factor portfolio is that the returns are almost identical. Largely all of Infinity Q’s Diversified Alpha fund’s performance can be explained by the factor portfolio containing the Volatility Alpha fund. The significant alpha that we identified with the VIX Mid-term factor is simply gone! The only change in the style portfolio was replacing the VIX Mid-term volatility factor with the Volatility Alpha fund.

It appears that all of Infinity Q’s Diversified Alpha fund’s “alpha” came from its volatility trade strategy, which is represented in our analysis by the exposure to its own Volatility Alpha fund. In the chart below we show the mutual fund’s performance (in red) and its attribution breakdown by factor with exposure to the Volatility Alpha fund factor accounting for 32.5% of the 38.8% of Diversified Alpha’s cumulative return since 2014.

Using known sub-strategies as regression factors for a multi-strategy product can prove very useful in identifying the source of both skill and risk in a more complex product. In the case of Diversified Alpha, this technique points to the Volatility Alpha hedge fund as the primary source of the “alpha” that is now being unaccounted for. Instead of poring over hundreds of different complex derivative contracts, if one could have identified that the volatility strategy was the source of the significant alpha generated by the Diversified Alpha Fund, this would have allowed one to narrow down the holdings investigation to positions that specifically represented volatility risk.

[1] The Infinity Q Diversified Alpha fund was revalued in March of 2021 from an $1.78 billion NAV (as of February 2021) to $1.25 billion – approximately a $500 million loss.