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.

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).

Where has all the alpha gone?

Where has all the alpha gone (to paraphrase a 60’s protest song)? Roughly, alpha is the ability to consistently outperform a well-defined benchmark. Alpha is notoriously hard to measure as most managers do not have records long enough to establish “consistently.” That matter aside, there are at least three forces compressing our notion of alpha – better benchmarks, better information and better liquidity. The traditional long only investing world has been wrestling with this issue for years, but the notion is now moving to the alternative space.

In the 60’s and 70’s, academic research on mutual fund results indicated that a better benchmark definition (compare a manager to a small cap index if she owns small cap stocks) diminished the perceived value added in fund results. Over the last 20 years or so, there has been an unknown quantity of permutations of alternative beta, hedge fund replication, liquid alts, and other repackaged versions of the same theme – to figure out if there is beta in the macho alpha alternative space. Continue reading

Benchmarking Alternative Beta

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.

Continue reading