Trend following investment strategies can benefit investors during periods of inflation and financial market volatility.
Trend following strategies capture upward and downward trends in traditional markets, which has made such strategies popular alternative investments for financial advisers looking to diversify client portfolios. This article from GSFM – which distributes the trend following Man AHL Alpha (AUD) strategy – examines trend following strategies, how they can provide alpha during market crises, and how such strategies can benefit client portfolios in an environment where inflation runs high.
Trend following strategies – also sometimes called managed futures or commodity trading strategies – seek to generate returns from sustained price movements, price trends or other repeatable patterns across a range of assets. These can be 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.
While the intricacies of such strategies lie in which markets are traded, the size of each position and risk controls; central to the strategy, however, is identifying whether a market is moving upwards or downward and the likely duration of that trend.
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: stocks, bonds, currencies, agricultural investments, commodities, interest rates, energy and utilities, and credit. Trend following strategies may invest across hundreds of markets and sectors at any one time.
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 clients’ portfolios, especially if you are concerned about the impact of increased volatility on those portfolios. Because trend following strategies invest across a broad range of assets, an allocation to trend following provides diversification benefits.
Since the global financial crisis, it’s been demonstrated that to protect investments during downturns, investors need to consider more than just a portfolio consisting of equities and bonds. In 2022, equity and bond prices have fallen in tandem, suggesting that while bonds have a role in a diversified portfolio, this role is not to mitigate loss in the equity exposure.
2. Correlation benefits
Trend following strategies generally exhibit low correlation with traditional assets – particularly equities and bonds – which can reduce overall portfolio risk.
3. 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.
4. 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.
5. Transparency
In the past, quantitative investing was referred to as ‘black box’ investing; advisers and investors did not always understand what it was or how it worked. Trend following strategies, are very transparent. Because it’s a computer-run strategy, the purchase and sale of assets are based on very specific parameters.
Trend following and inflation
Inflation is top of mind for many investors at the moment. Where will it stop? How far will rates rise to counter it? And importantly, what does inflation mean for their investments and how will it impact returns?
Over the past three decades, developed markets have not experienced a sustained surge in inflation. Accordingly, investors don’t always understand the impact of inflation on their investments. This is where advisers can help, to educate and reposition client portfolios in the face of the heighted 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 continued increases in real interest rates, an expected rate of inflation and risk premium. In the situation where there’s an unexpected surge in inflation, the expected inflation embedded in the yield increases, which means the bond price will fall. This has been evident in longer-term bonds during 2022.
If inflation turns out to be resistant to central bank actions, bonds with higher durations will be more sensitive than bonds with shorter duration. A change in the uncertainty about quantum and longevity of 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. Investors have witnessed volatility across equity markets for much of 2022.
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. This is the concern of economists predicting recessions in some developed markets, notably the United Kingdom and United States.
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 – commodities are often a source of inflation.
Trend following strategies have performed well in 2022 so far, outperforming not only traditional asset classes such as stocks and bonds, but also hedge funds in general (figure one). In fact, both the SG Trend and Barclay BTOP50 indices, which include trend following managers, have posted their best year-to-end-May returns since 2000.
Man Group’s research found for the first five months in 2022, pure trend strategies trading the largest futures markets have outperformed. The rationale for this is that macro-economic themes are driving markets; inflation, central bank activity, war, supply chain disruption, de-globalisation and post-pandemic recovery, to name but a few.
They are all interlinked, and are macro trends best observed in macro-sensitive instruments such as futures on global markets, be they country-level equity indices, government bonds or the largest of the world’s commodities. These are the traditional fare of CTA trend followers.
What are now called ‘non-traditional’ or ‘alternative market’ trend followers generally boast a wider range of price drivers and better diversification through trading a broad range of typically over the counter (‘OTC’) markets.
Portfolio diversification and inflation
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 has existed between bonds and equities.
The 60/40 approach 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?
Because inflation is bad for both equities and for bonds, it is also by bad for portfolios built using a 60/40 approach. Advisers need to look elsewhere for diversifying assets to de-risk client portfolios.
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.
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.
At its heart, trend following is an intuitive strategy; it should do well when markets move a lot, as they often do in inflationary environments. History shows that trend following can potentially do well after a period of inflation too.
Figure two illustrates that trend following is not only a robust performer during inflationary periods in general, but also in the last six months of the episode, as well as in the six- and 12-month timeframes following inflation’s peak.
When markets move a lot, either up or down, trend following strategies tend to do well. However, 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 performing as expected during this inflationary period?
- 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’.
You must be logged in to post or view comments.