In light of recent market performance, and the corresponding effect on changes in volatility on CTA returns we thought it important to give our views on the topic. Late last year, we were asked by a prospective client to see how one of our trend following models performed over several different stress environments. We highlight one particular stress that was given- a 20% stock market drop over 3 months, with 40% of move in month 1, 35% in month 2, and the last 25% of the move in month 3. A relatively straightforward exercise, but to really understand the nuances of different CTAs relative to our approach, you must look past just the change in level, but consider the potential price paths and volatility over that stress period. The difference boils down to whether one is viewing CTAs as a standalone investment, or as a piece of a larger portfolio, and the role of volatility targeting in position sizing.
The chart below shows the 3 prices series – the US 5 year yield, the US Dollar-Japanese Yen exchange rate and the price of gold – inverted here. Each of these markets have their own fundamental drivers, but for periods of time they can share the same set of dominant factors that determine price action. A story gets built around them that sounds compelling, and correlations become self-fulfilling…for a while. In previous years, these markets have been a popular way to trade interest rate views, but the recent divergence is fascinating. It’s a good example on the importance of focusing on the areas closest to home when taking macro bets, rather than being lulled into related markets that may be correlated at the time. If those correlations change, you can be right on the view, but wrong in the implementation. That’s no fun for anyone.
The narrative around each is decently intuitive – if you thought yields would go up, positioning in the currency markets where interest rate differentials are often dominant drivers makes sense. Nowhere is this more true than in Yen, which has arguably the most extreme form of easing in yield curve control, pegging the 10 year JGB around zero. Further, Japan appears to be the furthest major economy from tightening. This made sense for a while – as you can see in the run up to the US election and the reactions afterwards, perfectly fine way to play it. The gold view was also fairly compelling – low rates would lead to inflation, which gold is a great hedge against (not that we agree, but that was the view). So higher rates, particularly real rates, would push gold down. Again, in the run up to, and coming out of the election, this was an OK way to position. Spreading risk between the three expressions was a defensible thing to do. The second chart drums it home a different way – it shows just USDJPY and the US 5 year yield, and the 30 day correlation. That’s likely too short a window, and correlations are odd things, but it gets the point across – they correlated at 0.8 during these periods.
The recent move higher though…not so much. Gold has not fallen, and the Japanese Yen has gone the opposite way. Only the rates view worked. That 0.8 correlation went to zero on a dime. New narratives are popping up to rationalize it away and sound smart ex post – but ex ante it wasn’t clear at all. No one knows if it will continue or will revert either. Markets change and stories shift – the more things change, the more they stay the same.
There is a saying in our business,”the trend is your friend.” Given the recent downturn in trend following returns, I am reminded of another saying, “with friends like these, who needs enemies.” I was in a meeting recently with a consultant who asked a question we have heard many times over the years. How do you keep clients invested in managed futures in times like these? We know the history, the diversification benefits, the crisis protection, the long volatility profile…but, each time there is an extended period of challenging performance clients look to throw in the towel – because their equity investments are ripping up and managed futures is down. A good question, and the answer, I think, lies in the statement – it is a matter of faith.
Investors in the equity market have faith. They trust, and have been conditioned, that the market goes up over time, corrections are temporary. Participating in the capital formation of companies provides a risk premium to the investor and is an investment in the economic growth of a country.
Managed futures on the other hand is viewed as a trading strategy, it goes long and short, it is typically quantitative based. The perception is…I can’t have faith in a model, it can break. But this perception is misplaced, trend following measures a real economic risk premium in the market, just like equities (see older posts diving deeper on this topic, Portfolio Symmetry, Commodities are not Stocks, Benchmarking Alternative Beta). Investors in this market are rewarded by taking the price risk companies seek to shed. Faith should be in the durability of this premium, just like there is in the equity risk premium. Faith is gained by understanding this risk premium, when it works (periods of volatility and instability), and when it doesn’t (periods of low volatility and stability). Similar to equities, faith should be garnered from the underlying economics of the markets.
The MLM Index™ (see www.mtlucas.com for a description of the MLM Index™) does not include an allocation to equities. Many of our trend follower competitors do include them, and as a result we get asked all the time the reasons behind excluding them. As we have written about in previous posts (Portfolio Symmetry and Commodities are not Stocks), we believe that commercial markets like commodities, currency and interest rates are fundamentally different than equity markets, and need to be accessed in a different way, matching the economic rationale for the markets existence. Equity markets exist to fund the growth of capitalism and transfer capital from savers to businesses to be invested profitably. That’s a long only rationale in our mind, as the market participants are overwhelmingly one way. We think this is borne out by the tendency of equity earnings and prices to generally rise over time as economies grow. It also means that there isn’t a natural investment pool short the equity markets – no one has a business model that relies upon falling equity prices. One way you can see the differing utility functions is in the options market – implied volatility on puts trade at a premium to calls, as the demand for protection of a long investment book is much greater than the demand for call protection on a big real money short portfolio. Continue reading
The Bloomberg Commodity Index finished July down 12% YTD and 28% over the last 12 months. It is currently 60% off its highs in June 2008 (remember $150 oil?). Several large commodity funds closed in July. Does this asset class make sense? Our answer – absolutely YES – but commodities aren’t stocks so let’s stop benchmarking and investing in them the same way.