Sharpe or Skew?
Managed Futures offers this promise- uncorrelated returns with the potential for crisis protection. How an allocator chooses to allocate to this asset class is important. Do they judge managers by best risk-adjusted performance? Or do they judge managers by how they improve the risk-adjusted performance of the total portfolio? Do they view the asset as an absolute return element, prioritizing Sharpe Ratio, or as a portfolio element prioritizing diversification? Assuming the latter, prioritizing the addition of positive skew is critical to crisis diversification, offsetting the historically negative skew of the equity market and creating a better total portfolio.
Typical Managed Futures managers employ a risk controlled approach called vol targeting (we have written previously on this topic here and here). In essence, vol targeting involves increasing exposure when volatility is low and reducing it when volatility is high. Historically this has improved manager Sharpe ratio at the expense of skew. Our MLM Index EV and MLM Global Index EV are constructed a bit differently. While following similar trend following algorithms, positions are sized on exposure, not vol. The net effect is our indices are long changes in volatility, providing higher skew when needed most; in highly volatile markets. This makes intuitive sense; trend following tends to crash up while equity markets tend to crash down. The last thing you want to do is put the brakes on your diversifier while it is crashing up.
One opportunity this stay-at-home quarantine has afforded us, sad as it may sound to some, is increased time to work through the pile of academic papers on quantitative finance. It is amazing how much great stuff is out there. When you come across one that happens to be right in your wheel house and makes the case in a MUCH smarter sounding way than we ever can, all to the better. Such as it was with this recent piece – When it pays to follow the crowd: Strategy conformity and CTA performance by Nicolas Bollen, Mark Hutchinson and John O’Brien from Vanderbilt University and University College Cork.
The authors find that contrary to other areas of fund management in hedge funds and mutual funds, where being different is a positive trait (research on active share in the equity space is informative – see here), when it comes to CTAs/Managed Futures being a purist is the right approach. The authors analyzed the data using two different methods. First they sort funds into style groupings and calculate a Strategy Distinctiveness Index – funds that have low correlations to the style. They then look at the performance of portfolios of funds based on the SDI score. Second, they empirically check by rebuilding a simple model for standard trend following and regress funds against that model. Closer to pure trend the better.
We posted a blog on March 2nd discussing the initial reaction of managed futures to the market break as a result of COVID-19, including diversification and position sizing issues around volatility targeting at equity market highs. Today, we wanted to give an update on managed futures performance as the crisis has dragged out. We often tell our clients; building diversification into a portfolio and preparing for crisis events takes a multi-pronged approach. If you want instant protection to an equity market sell-off, long duration bonds provide the best bang for your buck. As a crisis extends bond protection is less reliable; this where managed futures (aka systematic trend following) steps in, accepting directional crash flows.
From the chart below (updated from previous blog), we see after a slow start managed futures has performed well, and more importantly, positive! Managed futures is a tough allocation to hold in good times, when volatility is low, when equity markets make new highs year after year. This is why you own it.
Managed futures is supposed to be a “profitable hedge” – long term positive returns with zero or negative correlation to the equity market. The recent coronavirus crisis highlights one of our core beliefs, namely that the construction of most managed futures portfolios diminishes that critical characteristic in two important ways. First, they include equity futures in the portfolio mix, and second, positions are adjusted for volatility. The combination of these two things is particularly deadly. There is nothing wrong with trend following equity futures. But anyone who watches the markets knows that equity vol is lowest at the TOP! That means that managers will have their largest equity positions at the TOP! Furthermore, when the market breaks, the eventual short position they take will be much, much smaller than the long they had at the top. In non-equity markets, the same can be true. In the recent virus break, crude was previously making new highs, then broke very sharply. Vol adjusted short positions will be tiny. Chart below compares a sampling of large blue-chip futures mutual funds with the MLM Index EV (15V) (which does not vol adjust).
Data source: Bloomberg LP, Mount Lucas
It’s a question of conflicting goals. If you want to maximize Sharpe ratio as a standalone investment, then vol adjust. If the rest of your portfolio is full of stocks and credits already, and you want a “profitable hedge” to maximize total portfolio Sharpe ratio, don’t. (See this blog post for more technical detail).
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 – http://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.