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The potential of trend-following strategies remains intact

Penalised at the peak of the European debt crisis by highly correlated and non-trending markets, trend-following funds have retained their unrivalled ability to improve the efficiency of an investment portfolio. Better consideration of the issues associated with risk allocation will strengthen these strategies’ potential going forward.

Article also available in : English EN | français FR

After two years of disappointing returns in 2011 and 2012, trend-following strategies – usually called trend followers or more generically managed futures – which offer highly diversified exposure to the global financial markets, experienced mixed fortunes in 2013.

The relatively poor 2013 performance of the Newedge Trend Index (2.67%), an index representing trend followers, could reinforce the negative view that some investors have of these strategies: models unsuited to the market paradigm that surfaced with the crisis, broken performance drivers and outdated strategies. There is quite a lot of criticism that trend followers have had their hour of glory and now no longer belong in portfolio allocations.

Yet, as is often the case, the reality is not so black and white. Although the indices tracking trend followers struggled to generate positive returns in 2013, the funds tracked by these indices also posted more varied returns than usual. Some even posted unprecedented gains, like the performance of over 16% achieved by the Epsilon strategy managed by the Lyxor Asset Management teams. Therefore, in many respects, 2013 cannot be summed up as another year marking the decline of trend followers. On the contrary, it heralds more of a revival for these strategies, which are among the oldest in the hedge fund universe.

A SYSTEMATIC INVESTMENT APPROACH FOR UNRIVALLED DIVERSIFICATION

To better understand the cause of the difficulties encountered by trend followers in recent years, a brief reminder of the founding principles of these strategies is required. Whereas traditional management relies on qualitative or quantitative analysis of asset prices, trend followers take positions in markets solely based on the price trend, regardless of the intrinsic value of assets.

An age-old phenomenon in the markets, trends are the product of inefficiencies originating in factors such as the difficulty some investors have in rebalancing their portfolios or the herd instinct of the markets. They also lend themselves well to a systematic investment approach that allows them to be identified for the purpose of taking financial positions.

By determining the statistical features of the behaviour of each market (e.g. volatility, correlation, average return, probability of a jump in the price level, etc.) that are likely to indicate a trend, the managers of trend followers can disregard the fundamental approach. Such a systematic approach, which does not require an in-depth knowledge of each market, enables them to expose the portfolio to a large number of markets at the same time. This results in an investment strategy with an unparalleled degree of diversification capable of generating returns in both bearish and bullish market conditions if trends are present.

UNCORRELATED YET DISAPPOINTING PERFORMANCE IN 2011 AND 2012

What went wrong in 2011 and 2012, resulting in poor returns for investors? Before answering this question, it is important to remember that trend followers experienced difficult years in the past. In 2003 and 2004, at the end of a downward rate cycle that had put pressure on the fixed income markets, an environment characterised by weak trends and a sharp rise in correlations among markets penalised model efficiency. The impact on performance was less severely felt, owing to the fact that money market rates – at which assets in a trend follower are remunerated [1] – were significantly higher than they are today.

1-PERFORMANCE OF TREND FOLLOWERS, INTERNATIONAL EQUITIES AND BONDS (JANUARY 2000 – JANUARY 2014)

A higher return than equities for a much lower drawdown

In 2011 and 2012, the market trend was basically a series of risk-on/risk-off movements that were very much dictated by the string of plans aimed at stabilising the international financial system. By causing periods of flight to quality (sovereign debt, gold, silver) followed by periods of repositioning on risky assets (equities, emerging markets, commodities, currencies), political interventions invalidated a number of trends identified by the statistical models used by trend followers. They also aligned all the markets which found themselves at the mercy of a single factor: political intervention.

At the same time, this simultaneous trend across all markets considerably reduced the effectiveness of a traditional risk allocation strategy. One of the basic principles of trend-following funds consists in taking positions in a large number of markets by spreading the risk evenly across all markets without appropriate consideration of the correlation. However, this simplified approach towards diversification seems to have reached its limits in 2011 and 2012.

2-TREND AND CORRELATION INDICES

A normalisation of the markets reflected in the return of trends and less correlation

Although the criticism against trend followers is based on the reality of a non-trending market environment marked by major interventionism on the part of monetary authorities, the asset class has probably also suffered from the comparison with other strategies with lower volatility, including those exploiting the bond recovery. However, trend followers retain all of their appeal, the main one being their strong decorrelating virtue, which has been constant since 2001.

3-ANNUAL CORRELATION OF TREND FOLLOWERS WITH THE MAIN ASSET CLASSES, 2000-2013

On average, trend followers are characterised by a low level of correlation with the main asset classes

MARKET NORMALISATION IN 2013

As illustrated in graph 2 on trend and correlation indices, the banking union agreement signed in the autumn of 2012 sparked a drop in correlation and breathed life into trend followers. They performed well until 22 May 2013 when the Federal Reserve announced the imminent tapering of the bond buying programme. The direction taken by the debate on the US federal budget then plunged the markets back into a period of uncertainty, which immediately resulted in another risk-on/risk-off environment until a last-minute agreement was signed in Congress in the autumn. This extension of the transition to a new monetary policy regime explains the mixed returns of CTA funds in 2013, owing to the difficulty in capturing trends in an environment that remained hazy.

Initiated at the end of December, the reduced monetary support to the US economy currently gives weight to the assumption that the systemic crisis has been defused and that risk-on/risk-off movements – detrimental to managed futures strategies – have been diluted.

RISK ALLOCATION’S TRUMP CARD

A closer look at the behaviour of trend-following strategies in a context of exceptional levels of correlation between the markets where only a single factor comes into play, as was the case between 2008 and 2012, reveals areas for improvement. Unlike in 2008, when persistent upward gold and commodity trends enabled models to shine, the lack of trends brought this to an end in 2011-2012. This episode calls for a reflection on the identification of market regimes.

The quality of the statistical models used to identify a market trend is the starting point for a trend follower. The high level of correlation seen in 2011 and 2012 highlighted the importance of the allocation model, whose ability to sufficiently diversify a portfolio is a prerequisite for the long-term success of a trend follower covering different market regimes.

A standard managed-risk allocation based solely on the know-how and experience of investment teams is not enough. Formalising the problems associated with risk allocation provides a more documented view of a position’s impact on the portfolio’s overall risk.

This is what has driven Lyxor’s research teams since 2011. Having proved conclusive over the nine months during which it was tested on a simulated basis, an alternative allocation model was rolled out in September 2012. For Lyxor, which is determined to stick to a trend-following strategy over the medium to long term where other trend-following funds allow themselves to vary their approach every so often, this new allocation model strengthens the management process.

A WELL-DESERVED PLACE IN ASSET ALLOCATION

A number of players in the collective, traditional and alternative investment business already realised the challenges facing risk allocation a few years ago.

For managers of trend-following funds, integrating these issues is strategically important. The challenge consists in building the competitive advantages that this strategy has over other asset classes in the long term.

In fact, in the long term, managed futures already display a better risk/return ratio than most of the other risky asset classes. They also stand out for their lack of correlation to the major market indices, which currently makes them one of the most effective alternative investment instruments.

For example, unlike long/short funds, whose performance includes, depending on the strategy, an equity, credit or bond component, trend followers do not have any structural relationship with a specific market. This decorrelation may be detrimental, particularly during market rallies when trend followers will underperform. Yet it has its advantages. When sharp downturns occur, as was the case in 2008, trend followers fare well, unlike other alternative strategies.

4-PERFORMANCE OF ALTERNATIVE STRATEGY INDICES SINCE 2000

Relatively stable performance over the long term

The performance distribution of hedge funds is radically different from that of trend-following strategies which have a positive skew. When they fall, losses are much less severe than what the strategy’s volatility would lead us to assume. And although they often shed little, they post a sharp rise when they make gains.

The introduction of trend-following strategies in a traditional portfolio reveals all the benefits of diversification. Thus, as might be expected from adding a decorrelated asset class to a portfolio, the mean-variance analysis of the returns of a portfolio composed of international equities and bonds, to which an allocation to a trend-following strategy is added, generates a more effective portfolio as it is more diversified. This positive observation justifies an unbiased examination of what trend-following strategies have to offer when defining the investment strategy.

5-EFFICIENT FRONTIER OF A PORTFOLIO WITH THREE ASSETS

Trend-following funds improve the efficient frontier

Guillaume Jamet , July 2014

Article also available in : English EN | français FR

Footnotes

[1] It is worth bearing in mind that most of the assets in a trend follower are composed of cash, only a fraction of which – generally 10-15% of the total – is used to manage margins required by counterparties.

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