CPD: Trend following strategies and crisis alpha

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According to history, trend followers have been able to perform well whether equities or bonds are rising fast or falling fast.

Trend following strategies capture upward and downward trends in traditional markets; this has made such strategies popular alternative investments for financial advisers looking for assets uncorrelated with equities, bonds and property. This article from GSFM – which distributes the Man AHL Alpha (AUD) strategy – examines trend following strategies, how they can provide alpha during market crises, and how such strategies can benefit your clients’ portfolios in an inflationary environment.

Trend following strategies, also sometimes called managed futures strategies, seek to generate returns from sustained price movements – price trends or other repeatable patterns – across a range of assets. These can be either upward or downward price movements. This approach is based on the premise that rising prices continue to rise and falling prices continue to fall…and for periods longer than expected if the movement was truly random.

In lengthy down markets, a trend following strategy will generally be positioned short to capitalise on markets continuing to fall. In prolonged up markets, the strategy will be positioned long in order to profit as the rising prices continue. Trend following trading is reactive by nature; it doesn’t seek to forecast markets or prices.

The investment approach employed by trend following strategies is generally a systematic, quantitative process that exploits a range of technical or price driven signals through investment in a broad range of futures and forward markets, as well as highly liquid over the counter (OTC) options markets. Strategies identify and capture trends across a range of sectors including stocks, bonds, currencies, agricultural investments, commodities, interest rates, energy and utilities, and credit. Strategies may invest across hundreds of markets and sectors at any one time.

Trend following is considered an effective investment because it removes the emotion from investment decision making. Investors typically suffer from behavioural flaws that can lead asset prices to move well above or below ‘fair value’.

Why invest in trend following strategies?

There are five key reasons to consider a trend following strategy for clients:

1. Diversification

Diversification is important for investor portfolios, especially if concerned about increased volatility; the global financial crisis demonstrated that to protect investments during downturns, investors need to consider more than just a portfolio consisting of equities and bonds. Because trend following strategies invest across a wide range of assets, it also adds important diversification benefits within the strategy.

2. Correlation benefits

Trend following strategies often deliver low correlation with traditional assets – particularly equities and bonds – which can reduce overall portfolio risk.

3. Transparency

In the past, quantitative investing had been referred to as ‘black box’ investing; advisers and investors did not always understand what it was or how it worked. Quantitative investing, and particularly trend following strategies, are very transparent. Because it’s a computer-based strategy, the purchase and sale of assets are based on specific parameters.

4. Risk/return

Trend following strategies can capitalise on a range of market opportunities to improve performance potential and consistency. When trend following is added to a portfolio of traditional assets, such as equities, property and bonds, overall portfolio volatility and drawdowns tend to fall.
Generally, trend following strategies have the capability to benefit from falling prices, which can help defend investment portfolios during periods of market drawdown. This highlights the importance of using a strategy that is true to label.

5. Liquidity

Unlike a number of alternative strategies, trend following strategies invest across hundreds of liquid markets and usually offer investors daily liquidity; trend following is much less likely than some other types of alternative investments to get ‘locked up’ in the event of a market crisis.

Trend following and inflation

Inflation is top of mind for many investors at the moment – what does inflation mean for their investments? How will it impact returns? How do investors respond to a world where both of its main performance drivers, bonds and equities, appear expensive relative to the past? With bond yields at exceptionally low levels, there is some doubt as to whether bonds can still protect equity portfolios in a sell-off as they have done historically.

Over the past three decades, a sustained surge in inflation has been absent in developed markets. As a result, investors are faced with the challenge of having little evidence regarding how to reposition their portfolios in the face of heightened risk posed by the current inflationary pressures.

Why does inflation matter for asset prices?

Treasury bond prices are impacted by unexpected inflation; current prices reflect an expected real interest rate, an expected rate of inflation and risk premium. If there’s an unexpected surge in inflation, the expected inflation embedded in the yield increases, which means the bond price will fall. If the new level of expected inflation is long lasting, bonds with higher durations will be more sensitive than bonds with shorter duration. A change in the uncertainty about inflation rates may also impact the risk premium.

Equities are more complicated. First, higher and more volatile inflation creates more economic uncertainty, thus harming the ability of companies to plan, invest, grow and engage in longer-term contracts. Moreover, while companies with market power can increase their output prices to nullify the impact of an inflation surprise, many companies can pass on the increased cost of raw materials only partially. Margins therefore shrink.

Second, unexpected inflation may be associated with future economic weakness. While an overheating may cause companies’ revenues to increase in the short term, if the inflation is followed by economic weakness, it will decrease expected future cash flows.

Third, there is a tax implication for companies with high capital expenditures because depreciation is not indexed to inflation. Fourth, unexpected inflation could serve to increase risk premiums (increase discount rates) reducing equity prices. Finally, similar to bond markets, high-duration stocks (particularly growth stocks that promise dividends far in the future) are especially sensitive to increased discount rates.

The inflation mechanism for commodities, like bonds, is relatively straightforward. Indeed, commodities are often a source of inflation.

Man Group’s analysis spans nearly a century. The long sample is particularly important because inflation surges in developed economies have been rare in the past 30 years. Some of this analysis reaffirms earlier learnings; for example, Treasury bonds do poorly when inflation surges. Commodities, often being a source of inflation, do well.

However, by way of example, commodities are a diverse set of assets and the inflation hedging properties depend on the individual commodity. Most importantly, the analysis shows that historically, high and rising inflation has been bad news for equity investors and risk parity portfolios.

The analysis also demonstrates that trend-following strategies have done particularly well during inflationary episodes and provides some degree of risk mitigation during inflation surges.

Portfolio diversification and inflation

Trend following strategies can add diversification to your clients’ portfolios in three important ways:

Firstly, trend-following managed futures funds are uncorrelated with equities and generally exhibit a negative correlation when equity markets trend lower. This means that they can actually counter, rather than merely cushion, the impact of a sharp downturn on an investment portfolio.

Secondly, the sheer range of opportunities that can be accessed through a constantly-evolving universe of futures contracts, forwards and options, each component of which can be traded both long and short.

Finally, the use of futures contracts allows the manager a much more diverse exposure for a given amount of capital than would be possible from investing solely in the underlying assets.
While diversification is a key tenet of investing, for the past 20 years or so many portfolios have been based on the 60/40 rule of thumb – 60 percent exposure to equities, 40 percent exposure to bonds. This has worked because of the negative correlation that’s existed between bonds and equities (figure one).

Interestingly, this chart illustrates that this environment of negative bond equity correlations has really only existed for the last 20 or so years. When you go back further – and this chart goes all the way back to 1765 – it becomes evident that this negative bond equity correlation is a fairly recent phenomenon and not something that’s typical of the investment landscape.
The 60/40 strategy has worked well because of this negative correlation; whenever equities haven’t performed well, bonds tend to do so, and vice versa. The question becomes, is that likely to persist going forward, given the current investment environment where equities are at all-time highs bond yields at all-time lows?

Inflationary times are bad for both equities and for bonds and by definition, for portfolios built using a 60/40 approach. Interestingly, there have not been any periods of sustained inflation over the last 20-30 years. If that were to change, can bonds be relied on as an equity hedge? What can investors do in an environment where traditional assets are expensive and inflation likely to rise?

Given that inflation is bad for bonds, and that historically, negative correlation between the two has not existed, advisers need to look elsewhere for diversifying assets to de-risk client portfolios.

Crisis alpha

‘Crisis alpha’ is a term coined to describe the tendency of trend-following strategies to perform well when markets are in crisis. This is because the return stream from trend following strategies are generally uncorrelated to equity and bond markets in the long term and have the potential to perform well in times of market stress.

Figure two separates 50 years of data into quintiles. The worst annualised returns are shown on the left hand side of figure two, moving across the best towards the right hand side. Broadly speaking, figure two illustrates that during equity crises, trend following strategies tend to do well.

Similarly, on the right hand side where the best quintile resides, trend following strategies also tend to do well. In other words, when there’s a lot of movement in equity markets, trend following strategies tend to do well. The blue ‘smile’ is indicative of the return from trend following strategies.

When markets move a lot, either up or down, trend following strategies tend to do well. The returns illustrated in figure two, as shown by the coloured bars, are well distributed between bonds, commodities, currencies and equities. A trend follower will trade all of those markets and can potentially be profitable in doing so.

Most notably, in equity market falls, trend followers tend to outperform. Similar research into bond markets has similar findings; when bond markets are falling, trend followers tend to do well.

When considering a trend following strategy for your clients, there are some important questions to ask:

  • Is the strategy true to label and has it remained so over time?
  • Has the strategy delivered crisis alpha in times of market downturns?
  • Is the strategy liquid and transparent?
  • Does the strategy harness the latest technology – machine learning, artificial intelligence, platforms for swift execution of trades?

According to history, trend followers have been able to perform well whether equities or bonds are rising fast or falling fast. This provides confidence that in a period of rising inflation, should equities and bonds both fall at the same time, a trend following strategy should be able to do well and provide ‘crisis alpha’.

 

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Important information: The information included in this article is provided for informational purposes only. The information contained in this article reflects, as of the date of publication, the current opinion of Man Group plc and is subject to change without notice. Sources for the material contained in this article are deemed reliable but cannot be guaranteed. We do not represent that this information is accurate and complete, and it should not be relied upon as such. Any opinions expressed in this material reflect our judgment at this date, are subject to change and should not be relied upon as the basis of your investment decisions. All reasonable care has been taken in producing the information set out in this article however subsequent changes in circumstances may occur at any time and may impact on the accuracy of the information. Neither Man Group plc, GSFM Pty Ltd, their related bodies nor associates gives any warranty nor makes any representation nor accepts responsibility for the accuracy or completeness of the information contained in this article.

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