With Trend Following – Beta Is Not Just Fine, It Is Preferable

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.

From the conclusion:

“Prior research has shown that strategy distinctiveness is a key determinant of cross sectional differences in hedge fund and mutual fund performance. It is intuitive that funds with more unique strategies should outperform, as the returns to more well-known strategies are competed away. However, futures markets are characterized by a high level of momentum, leading to the prevalence of trend following strategies. Consequently, trading against the crowd while pursuing an independent strategy may incur a high risk of failure.

We measure the distinctiveness of a CTA’s investment strategy following Sun et al. (2012). We estimate the correlation of a CTA’s return with that of its peers and classify funds with low correlation as high SDI funds. Our key result is that, in complete contrast to prior literature on SDI and hedge funds, SDI is negatively associated with future CTA performance. Funds that are more unique tend to underperform, after controlling for risks and styles, irrespective of holding period. Moreover, our evidence indicates SDI is an informative measure for predicting CTA performance only during times when momentum trading in futures markets yields positive returns. In summary, the best performing CTAs trade largely on momentum, and offer investors exposure to this strategy. Investors can realize a benefit over the full sample, but suffer losses when momentum strategies fail.”

A short interlude for some history on the authors of this blog. Mount Lucas has its roots at Commodities Corp, one of the birthplaces of the hedge fund industry some forty years ago. We spun out as we began to take on public pension plan clients, who subsequently required a benchmark for our performance. Remember, this was the 1980s, before there existed more indices than stocks and an index for absolutely everything. There were few benchmarks, and certainly no proper price based benchmarks for alternative investments. So we built one; the MLM Index. It is not exactly the same as the model used in the paper we are discussing, but its close enough to be representative. Long term trend following in a diversified set of representative markets. Although we have added some markets over the years, and altered the implementation a little, it has stood the test of time and is still running today. It is a great way to access the beta of CTAs and Managed Futures.

To our mind, if an investor’s goal is to obtain a representative, pure trend following return stream (and in our view it should be a component of all portfolios – see here) and being closer to the pack is a positive, then a low cost Index approach is a fine, if not preferable, solution.

Value and Rebalancing

The temptation is strong. The strategy you have used for years has underperformed. Why take the risk? Move back to the benchmark. Like a remake of a classic film, we have seen most of this before. In early 2009, pressure was on value stock managers to change their stripes. We recall a conversation from April 2009 with a foundation client invested in our Large Cap Value strategy. We had recently rolled to a new portfolio, and one of the selections was Wyndham Hotels. They were quite agitated – after the financial crisis it was unlikely that people would be going back to hotels for years. How could we? I took the quant’s way out of the question – “the model made me do it.” Wyndham was the best performing stock in the S&P 500 over the next 12 months.

The current reckoning certainly rhymes with the financial crisis. We must confess that even our conviction was challenged this time, and I promise you, ours runs deeper than most. Last week it was time to roll our value portfolio forward. Put the names back into the hat, take a fresh look, buy what is cheapest based on the models and caveats we employ. To add to the insult, it was also time to rebalance our multi-asset portfolios. What this meant was we had to buy a portfolio of decimated value names, in some cases buy more of them. Alaska Air? Kohl’s? Valero? MGM? Who is going to fly, go to a department store, get gas or gamble? Sure, these stocks have never really been cheaper, but come on. This is wake up in the middle of the night with these ticker symbols swirling in your head stuff. And you want us to buy more!

Take a deep breath. Think for a minute. What works? Buy when others are selling, sell when others are buying. Buy zero coupon bonds in the early 1980’s. Sell tech and buy value in 2000 (value was “broken” then, too). Sell crude at $150 (that’s when people stop buying gas). Value stocks look like that right now. They have discounted the end of air travel, retail, gasoline, and gambling. Never again will there be cash flow or dividends. We aren’t blind, we get that the near term is difficult for these names. But does that justify low single digit PEs? Or should it be mid-single digit PEs? Or can you look forward a few years and imagine a world different than today. For at least part of your portfolio, don’t you need to own the cheapest assets in the world? Rebalancing works best when you have volatile assets with low correlation and positive return – pump that volatility. What you shouldn’t do is sort by near term returns top to bottom and pile into the biggest winners. That’s not a portfolio.

Value stocks at this juncture are incredibly cheap. We aren’t the first people to say this, but it bears repeating nonetheless. The chart below shows the ratio of S&P Growth PE ratios to S&P Value PE ratios. There are bargains galore on offer, right now. Great businesses that are temporarily troubled and are being penalized to extreme degrees. Take advantage of it.

RatioSPGrowthValuePE

Data Source: Bloomberg, Mount Lucas LP

Managed Futures and the Virus: Update

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.

ManFutAndTheVirus2

Data Source: Bloomberg LP, Mount Lucas

This chart compares a sampling of largely blue-chip managed futures mutual funds (Fund 1 is a multi-alternative fund that uses managed futures, but clearly has an equity bias) with the MLM Index EV (15V) (which does not vol adjust).

Managed Futures and the Virus

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).

Correlation Is Not Causation

Drummed into applied math students everywhere. It even has its own website, with this gem on how margarine consumption is correlated with divorce rates in Maine.

correlation

Should be true enough in markets as well. But in reality, at least in pockets, it isn’t always true. Stocks have always in part been driven by relative valuations. Stat-arb was a big thing some twenty years ago when computing power was starting to be applied to stocks. Pairs trading based on common risk factors makes some sense, Ford and GM operate in the same business after all, it makes sense they should be broadly be impacted by the same broad industry and economy trends. When computing power jumped later, factor investing came to dominate. Grouping stocks based on different attributes has some merit. At their heart, the old quants had valuation firmly in the mix of parameters. Many of the newer factors and machine learning quants have thrown out what ultimately matters. Price – or rather ‘value’. Low vol investing doesn’t care whether a stock is priced for perfection or not. Quality takes no account of what that pricing implies going forward, just that its metrics are stable. Momentum will push junk yields far below default rates and not even notice. As long as the quants see the property they like, regardless of valuation, away they go. They operate as if they are just observers, quietly taking a look from afar and being able to interact without impact. The Hawthorne effect is the phenomena where the behavior of subjects is altered due to the awareness of being observed. The quants in places are not observing any longer, and their impact is self-fulfilling, for a time anyways. There is plenty to be gained from applying stats and metrics to markets, but it is surely important to not take it too far.

You can see this today (September 9, 2019). ‘Value’ stocks are up a lot, not particularly based on the merits of the underlying businesses, but because other types of stocks are down. When stocks are held for their correlation properties, strange things happen. Like the butterfly that flaps its wings and causes a distant thunderstorm. It’s easier to make a case that at least today, retail stock Gap is up big because Boris Johnson chose to shut down parliament. Not often thought of as a butterfly, but bear with the logic here. Boris shut parliament…which catalyzed votes to stave off ‘no deal’ Brexit…which caused Gilts to fall…which drove global bonds to fall…which pushes growth stocks, utility stocks and REITS down…which makes value stocks jump. Seem strange? It should. But the stock market acts this way more and more. Factor investing and ETF baskets that segment stocks into groups are big drivers of prices, particularly when smaller names get larger weights in factors. We need to get back to a more fundamentally driven world.

Looking Beneath The Hood Of Factor Investing

Factor investing, particularly within the scope of risk premia strategies, has been a popular topic. Vanguard has convinced the investing community that beta can be achieved by buying passive indices and the cost of owning beta should be very low. Investors use risk premia strategies as a source of generating alpha.   But …. are people looking carefully enough when evaluating these strategies? Much gets hidden in broad risk and return statistics. We thought we would take a deeper dive into how factors behave over market cycles. Continue reading

Can News Flow Create Value?

Searching Google for “Retail Apocalypse” returns 8.8 million results (in .45 seconds!). For the better part of a decade the sector has been beaten up in the press. The headlines are not unfounded. Former staples of American consumerism such as Toys-R-Us, Radio Shack, and Payless ShoeSource are no longer, while many others struggle to find stable ground. The negative hype surrounding the Retail Apocalypse has created a fog around the whole sector and retail stocks have not been a popular pick amongst active money managers in recent memory.

Behind the retail apocalypse headlines are companies who have adapted to new market conditions, have strong balance sheets, and forward-thinking management. Looking into the fog, we see a shunned sector, overly beaten down valuations, and good potential to seek out value. Our Mount Lucas Focused Large Cap Value currently holds 4 retail names amongst its 36 total holdings. Some may view this as a high concentration of an unpopular sector for a focused strategy which holds no more than 40 stocks. However, our quantitative stock picking algorithms have no such opinions, they are programmed to seek value.

Below are the 4 retail names currently being held in the strategy, each picked for the portfolio on Sept. 22, 2017. Presented are price charts with selection date indicated and resulting price move, as well as headlines from the time preceding selection. Even positive news is tinged with negatively worded headlines. We believe this illustrates the headline fear and peer pressures that all human stock pickers face, as well as the benefit of a non-biased quantitative approach to value investing.

Mount Lucas Focused Large Cap Value Strategy Information

Continue reading

Stress Testing CTA Portfolios – Impact of Volatility Adjusting Positions

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.
Continue reading

The Doldrums

In the great series of historical novels about the British Navy in the Napoleonic era by Patrick O’Brian, and the associated movie Master and Commander, there is a poignant scene where the ship is stuck in the Pacific doldrums, sails limp at the mast for days. The crew looks for a scapegoat, a Jonas, to blame for their misery, and they find one in a hapless midshipman. For the good of the ship he grabs a cannonball and jumps over the side. A prayer is said, the wind returns, and off they go. Complacency is the buzzword of the day, but the winds will return as they always do, and the catalyst will be as much a surprise to the market as to the midshipman who found himself carrying a cannonball.

I am habitually early for meetings. The other day I had some time to sit outside the offices of a major investment bank at the start of the business day. It’s an evergreen notion for me … a scene repeated at all the banks and funds all around the world, hundreds of well educated, motivated, energetic young people all chasing the same pool of alpha. And I wonder, is there enough to feed all these hungry strivers? Risk premium is durable, varied and growing, alpha is zero sum and rare. At Mount Lucas, our approach is to own that risk premium in many flavors through our quantitative trading. Just this month we added a new flavor, a momentum based multi asset credit basket. It fits nicely with the other risks in our capital markets allocation. We continue to search for alpha in the realm of long term behavioral biases. I have to admit it’s tough going, particularly in the doldrums, but the opportunities are there, and we await a stiff breeze to see them realized.

 

Mount Lucas employs a number of different strategies each with their own investment objectives and risk profiles.  Any reference to a strategy or strategies mentioned above may or may not be indicative of all of Mount Lucas’ products.”

With Friends Like These…

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.