By Howard Moore
There are many reasons to invest in trend following: it diversifies, it tends to be non-correlated with other markets, and it’s liquid. It can take the form of a managed futures or commodity trading advisor (CTA) strategy by trading derivatives of a wide range of markets, including equity and fixed-income indices, commodities, currencies, and interest rates. Sometimes it outperforms in a crisis, as it did in 2007–2008, when managed futures funds returned 14 percent, while the S&P 500 index fell 37 percent and hedge funds, on average, fell 20 percent.
This gave trend following a reputation of being a risk mitigation tool, or at least a crisis risk offset. And while there may be times when it functions that way successfully, that’s not what it’s designed to do, and in any given crisis its ability to protect a portfolio is an open question. You need look no further than the equity sell-off in February 2018 for an example. Many trend-following portfolios were constructed around Treasuries, but those sold off along with equities, which is not what investors expected.
What trend following is designed to do is provide liquid diversification that can improve a portfolio’s risk-adjusted returns. The SG Trend Index, which tracks trend-following strategies, has returned an annual average of 5.9 percent since 2000. “It’s a diversifier rather than a hedge or an offset,” says Philippe Jordan, president of Capital Fund Management (CFM) International, a global quantitative and systematic asset management firm founded in 1991. CFM researches and implements numerous alpha and alternative beta strategies, including long-term trend following, which, Jordan adds, “is a portfolio construction benefit that over time can bring robustness to investments in traditional equities and fixed-income.”
Maintaining a consistent, long-term trend-following strategy is key to capturing upside opportunity. “If you jump in once a trend starts, by the time you participate, you will have missed 30–40 percent of whatever that trend was about,” says Jordan. For example, Brent crude oil traded in a relatively tight range with little volatility for the first six months of 2014 before dropping nearly 60 percent, from around $115 to $46 per barrel, over the next six months. A year later, in January 2016, it fell to $28. “That was a trend that developed very quickly, and if you weren’t already systematically exposed to trend, you wouldn’t have captured it,” Jordan says, noting that it’s not possible to time a move in the market. Much like equity exposure, an investor needs to own the risk through the peaks, troughs, and sideways markets to capture returns effectively.
Tendency to crash up
Trend following tends to crash up, as opposed to equities and fixed income, which tend to crash down, making it an excellent diversifier. “It’s a positively skewed strategy,” says Jordan. In terms of return, the days of low amplitude tend to be negative, but those of high amplitude tend to be positive. Over the course of weeks and months, trend following may lose money, but a big day could mean significant returns. When properly implemented, it should have a Sharpe of 0.5 to 0.7, according to Jordan. The S&P 500 has a Sharpe ratio of about 0.4, but over the course of 12, 24, or 36 months, trend following should have a low correlation to equities.
On a standalone basis, trend following should reduce a portfolio’s volatility and increase its Sharpe ratio, boosting risk-adjusted returns. “That’s the value,” says Jordan. The misperception is that it’s a hedge for a short-term equity market crisis. “If there’s a sharp drop in equities, trend following may be up or down – it’s a toss of a coin,” he says. But over time, say six months or throughout a protracted bear market, trend following would perform by shorting the market incrementally and maintain a correlation close to 0.2 or 0.3 to standard equity and fixed-income benchmarks.
Trend following strategies can incorporate nearly 200 liquid financial instruments, and portfolios can be long, short, or long-short. “We organize portfolios around a particular contract’s modes,” says Jordan. In addition to trend, CFM regresses a contract’s principal components—those elements that have explanatory power over its price variance—and controls their exposure to the market, similar to equity market neutral or equity statistical arbitrage. For example, it could be the growth or value factor in a stock or, in an oil futures contract, the crack spread, the differential between the price of crude oil and the various petroleum products extracted from it. “We apply those same principles in a long-term trend-following portfolio,” he says.
Flows into trend following strategies are growing. Investors like their uncorrelated and diversifying characteristics as yields remain low, interest rates rise, and equities appear overvalued. “There’s a renaissance,” says Jordan, who notes that investor interest is cyclical. There can be bursts of performance than can last a year, two years, or three, but the strategy can also go sideways or down for protracted periods, which leads to investors trying to time the market. “That tends not to be successful,” he says, explaining that investors are much better served when they define and own a reasonable amount of risk over time, and that risk is reasonable and expressed in line with expectations. “To extract the maximum, rational amount of value, you have to own the risk through the cycle.”
Download “The Convexity of Trend Following”
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