Can trend following make money in a low rate environment, and is it all bonds?
We often get asked whether trend following strategies can make money in a low interest rate environment, or in a similar vein, if trend following is just a levered long bond position that’s now run its course. In short, we think that higher rates can help some aspects of trend following strategies, but certainly should not be a driver of a long term allocation decision. The portfolio benefit of an allocation to trend following to an investor or plan with more traditional equity and credit market exposures is not solely – or even largely – driven by the fixed income exposure. Using a simple trend following model in commercial markets (commodity, fixed income and currency – we explain here why we think that’s the right approach) below we break down the sources of returns in times of crisis, and suggest an economic rationale as to why it isn’t just about bonds.
We’ve written before on our view that most investors are generally overexposed to the investment risk premium, and underexposed to price risk premium, and why these premiums when combined make an attractive portfolio. Briefly, investment risk premium thrives on stability and growth, while price risk premium thrives on instability. The two are uncorrelated most of the time, and negatively correlated in times of stress. It’s natural to think that given one element (the largest on an exposure basis) of the price risk portfolio side is bond trading, and bonds tend to rise in time of stress, that the driver of trend following returns in times of stress is largely fixed income. Given the current level of global interest rates, it’s a fair question – but only part of the story. We will use the crisis of 2008 to illustrate – if there was ever a year an investor wanted a crisis hedge, 2008 was it. The chart below breaks down the asset class returns of the MLM Index (our trend following index created in 1988) as the year progressed.
Fixed income trading is the lowest contributor, pretty incredible given it had the largest allocation (42.5%) and it was a crisis year that started with the Fed Funds rate at 4.25% and ended with it at zero. Commodity (25% allocation) trading and currency (32.5% allocation) trading both make larger contributions. The first half of 2008 was as much about the path of oil prices as anything else – crude ended 2007 just under $100/b and went pretty much straight up through the end of June, great for trend following positions. The Fed spent much of this time worried about inflation and second round effects, the ECB actually hiked rates on the eve of crisis. July and August saw an abrupt turnaround in oil, hurting the trend positions before they turned short, performing extremely well through the worst of the crisis in the last quarter of the year as oil fell from $100/b to $40/b as global recession took hold and demand fell. Currency trading moved in a similar fashion, generating returns in the last quarter as the world scrambled for USD as a safe haven. It took until the last 2 months of the year for fixed income positions to make any money at all in this model, and they have done well since.
As we said above, the price risk premium thrives on instability, which creates large flows across global markets. You don’t know in advance where the flows will be, but you do know they are coming. Risk has a way of bubbling up when suppressed, markets need a pressure release. Even today if bonds are unable to act as the pressure release conduit given low yields (which isn’t clear given quantitative easing, negative interest rates and the collapse of term premia – we’ve certainly seen over the past couple of months bond yields fall as global growth expectations have fallen) it will manifest itself elsewhere, in currency markets or commodity markets. Trend following is not reliant on bond prices rising to act as a crisis hedge.
Having said that, the most obvious place higher interest rates can help the strategy is the seldom mentioned return on unencumbered cash that used to generate something approximating the 3m T Bill rate. This could offset a good amount of losses in choppy markets. Not earning 3-5% a year on cash for the past 8 or so years adds up.
One of the incredible things about trend following is its longevity, and how it has performed in a broadly similar fashion across many different environments – high rates, low rates, high commodity prices, low commodity prices, and many different FX regimes. It does so because of the inherent way markets operate. Our view is that investors should build a robust portfolio designed for the whole cycle, and that trend following is a critical component of that portfolio.