A recent Bloomberg News article (https://www.bloomberg.com/news/articles/2019-03-01/one-of-wall-street-s-most-popular-trading-strategies-is-now-failing) mourned the passing of a venerable quantitative trading strategy – Trend Following. The central claim of the article is that the strategy is antiquated relative to the speed and variability of modern markets. We have been doing this for 40 years – it’s not the first time we have heard this. There is no denying that trend following has struggled, but we think the article has the reason exactly backwards.
The investment world’s conception of trend following has changed over the years. Practitioners of the craft were, in the 70’s and 80’s, viewed as highly skilled magicians, teasing returns out of the tangled chains of futures markets, worthy of fees supporting retirement owning Major League Baseball teams or living in mansions in Mayfair. Starting in the late 1980s, investors began to think about trend following in risk premia terms, reproducible factor returns – more science less magic. Like other risk premia, trend results are highly variable (see our view on risk premia here – https://blog.mtlucas.com/2019/02/28/looking-beneath-the-hood-of-factor-investing), with recent trend returns on the downside of that variability curve. We thought we would take a closer look at what is driving those lower returns, and why and when they may change.
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.
Fed Chair, Janet Yellen said yesterday that economists were not good at stock valuation, but that she saw no red or even orange signals. Here’s one … The S&P 500 Relative Strength Index, a measure of “overboughtedness” is the highest it’s been in 20 some years – by a lot.
If nothing else, points out the contrast between the tech bubble and today’s market.
St Louis Fed President James Bullard has released a paper detailing a revised approach to economic forecasting. It’s a very smart way of looking at the world – read it here. Briefly, he is saying that the current way of viewing the world as converging to a single state is no longer useful and instead should be thought of as a set of possible regimes the economy could visit, with the regimes being generally persistent, requiring different monetary policy responses, and switches between regimes as not being forecastable. In his submission to the FOMCs quarterly economic projections, he declines to provide a forecast for the ‘Long Run’, as it is outside his model projection range. His low projection of the Fed Funds rate over the coming years reflects his view that the present regime has a low neutral real interest rate, a switch to a higher regime is unforecastable. If it were to happen, it would cause a change to many variables – policy would not reflect a gradual shift to a single state, but would have switched regimes.
This approach to forecasting was pioneered by James Hamilton. The math is pretty complex (lots of markov processes, etc.), but here is a simple way to look at it. Suppose we have two possible states in the world, the bull state and the bear state. The variable that determines the state is unobservable, and since you can’t see it, you can’t forecast it. Suppose in the bear state that the daily returns to an asset, like the stock market, are selected from a normal return distribution with a negative mean. Conversely, in the bull state, the mean is positive. If the state variable is pointing at bear, the trend will be down, if bull, the trend will be up. The trendiness of a market is determined by how likely we are to remain in the current state. For example, if the probability of jumping from one state to another is 5%, trends are more likely to persist than if the probability were 20%. What causes the state variable to jump is unknown, as Bullard describes.
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.
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 year 2015 will mark Mount Lucas’ 30th as an alternative investment manager. We formed as a CTA in the halls of Commodities Corporation in Princeton, New Jersey. Our particular mandate was to attract managed futures assets from the institutional marketplace. In doing so we became the first managed futures manager to register with the SEC as a Registered Investment Advisor. Just two years later our we created the MLM Index – the first price based index for Managed Futures – and possibly the first attempt at measuring alternative beta.