Correlations, Risk Parity and Trend Following

It is a common refrain that, in a crisis, asset price correlations move towards 1. What was once independent is no longer so, as a large common driver has emerged creating large and often forced flows from leverage unwinds and VaR models that then feed on themselves. This is shorthand – what really happens is correlations move to extremes.

Over the past 40 years or so, generally speaking, stocks and yields have been positively correlated. There were a couple of short-lived hiccups around the taper tantrum and early 2007 which soon reversed. In previous periods of stock weakness, you can see the correlations move decidedly higher.

Source: Bloomberg, Mount Lucas

We aren’t the first to write about this being the foundation of most portfolio allocations. Yields drop and bond prices go up. A positive carry reliable portfolio diversifier- the holy grail to those that practice the dark arts of optimization. We also aren’t the first to point out this has been made possible due to generally low and steady inflation, meaning in periods of crisis or economic weakness it has been fairly easy for central banks to ease policy, underpinning the correlation. This chart from Goldman Sachs illustrates this.

Risk parity portfolios are an example of this type of construction. Sometimes they add in other asset classes as well – credit, REITs, commodities etc. One drawback as we see it: they are long only. When correlations move toward 1 in a crisis, and you are constrained long only, you only get to choose from one side of the return distribution; you need the asset to go up. Managed Futures have shined in previous periods of crisis, and done well as an equity market diversifier, by capitalizing more fully on the correlation moves. They allow exposure to the big negative correlations also, and in more places than investors typically have exposure – like currency markets. To our eye this is a huge improvement over long only methods of portfolio construction, and why we think Managed Futures strategies warrant a place in all types of portfolios.

Take crude oil for example. In a crisis, correlations move to extremes. Sometimes that correlation is near 1 like in 2008 as crude as crude collapses alongside stocks. Sometimes that correlation is near -1 as in early 2022 as crude gained and stocks fell. You need the short side of markets to capture the broadest range of moves to correlation extremes that you can. Managed Futures, in a crisis, hones in on the big flows and macro uncertainty that hurts equity markets whether those moves are caused by other markets going up or going down. 2022 is a great example of the need for both long and short exposures. The stock markets prime concerns in 2022 have been soaring commodity prices and collapsing bond prices. Strategies that rely on only the long side are at a disadvantage.

(PS – Couple of smaller points – on Managed Futures execution, it helps to do another couple of things under the hood, which we have written about in the links that follow. First, when Managed Futures are locked in to diversifying positions in a crisis mode – hold on. Don’t adjust positions just when the volatility picks up. More here. And second, stick to major markets. It is those that cause the systemic issues or capture the biggest crisis flows. More on that here.

As We See It: Small Markets

Right to the Source ….

The current trend in the managed futures world is … expand the portfolio, trade every little market in every suspect exchange around the world to get the maximum diversification. That’s fine I guess if your goal is to create a standalone investment with the best possible Sharpe ratio. But if your goal is to diversify a broader portfolio, adding many second-tier markets may be counter-productive. Let me explain.

Right now, moves in the stock market are being determined by moves in the 10yr Sterling bond, the gilt, and as the LDI debacle unfolds and spreads into other markets. Gilts down, stocks down. All concentrated managed futures portfolios would trade the gilt, and would be short. However, if your fixed income portfolio trades a zillion different bond and interest rate contracts, the impact of that gilt short, and its diversifying character, would be diminished. It’s highly unlikely that something that happens in Sweden or Thailand would have the same impact as something that happens in the UK, a major money center. It’s the major things that cause major problems in equity and credit markets. A more concentrated managed futures portfolio is likely to have more exposure to those major drivers.

This problem gets compounded by the desire of quants to “risk adjust”. In the current environment, risk adjust means cut the gilt short because volatility has gone up. That may risk adjust for the manager, but not the holder of the broader portfolio. He now has less participation on the source of market volatility. We’ve written more about how that looks in a portfolio here and here.

Remember, what’s good for the manager’s Sharpe ratio may not be good for your portfolio Sharpe ratio.

Managed Futures In The Portfolio – Update

2022 has been an awful year for most all assets. Through the end of the 3rd quarter, the S&P 500 is down 23.9%, High Yield bonds down 14.4% and Investment Grade bonds down more at 21.2% (worse than HY due to the longer duration in IG). Over the past few decades, investors have been somewhat accustomed to seeing US Treasuries do well in tough times for equity and credit markets, this year though, 7-10 year US Treasuries are down 15.7%. It’s an ugly scene…not a lot of places to hide.

Source: Bloomberg, Mount Lucas

One bright spot – Managed Futures strategies. We wrote about these earlier in the year here. Our long-held view is that Managed Futures are fantastic portfolio elements. We like them more than most – and execute them in a purer form than most as well – but recognize them for what they are. A Portfolio Element. Most investors, us included, hold portfolios of stocks and credits. To our eye these are also Portfolio Elements. Stocks tend to do well in times of economic stability, growing earnings and rising multiples. Managed Futures tend to do well in periods of macro-economic uncertainty and instability. Combining these two elements makes a lot of sense to us.

As with all portfolio construction, the only thing more important than having a plan is following a plan. Rebalancing is plan-following in action. In the years prior to the pandemic, it had been a fairly fallow period for trend following strategies. Continuing to hold exposure to portfolio elements that are out of favor for a period is not easy to do. A lot of investors start with a great portfolio of undiversified elements, then at the end of every year take a look down the list of line items and chop the bottom few. If you do this a few times in a prolonged cycle, you end up with quite a correlated book – whether you notice it or not. This happened pre 2008 when both energy stocks, emerging markets, commodities and carry strategies were all doing well. If you aren’t careful and you chop the other pieces as they underperformed and didn’t rebalance the winners, you end up with a chunky overweight in those things. As that cycle continued it became fairly clear the drivers were narrowing. Commodities were going up, which helped energy stocks. It also helped emerging markets, which at the time were more heavily raw materials based economies. Hot money flows into the markets amplified the FX component of the returns too, and in currency carry the commodity currencies were outperforming and had higher rates. They all unwound together.

Fast forward to the past couple of years. Tech has been doing incredibly well – fabulous business performance, network effects, buybacks and multiple expansion. Venture capital had been doing well. The broader stock indices became more concentrated along the way, and low rates seem to boost steady subscription type businesses and REITs. We have a common factor forming. The cycle extends and credit spreads tighten, borrowers extend and refinance into new bonds at lower coupons, increasing duration and reducing risk premium. Government bond yields got lower and lower, as they were the perfect component – uncorrelated to negatively correlated positive carry hedge. Managed Futures allocations…some folks maintain in dollar terms, others reduce or cut it, or don’t rebalance into it, letting the weight drop.

This year so far, when everything else has been getting hit as the common Achilles heel – inflation – rears its ugly head at a time when with hindsight, stocks and bonds were priced for perfection. An ugly war in Europe didn’t help either. The definition of macro-economic uncertainty into markets that were priced for stability. Record high SPX at a 23PE, a US30 year yield under 2% and high yield spreads at just 3% – less than most estimates of full cycle default rates. A rare bright spot in a sea of tough market returns? Managed Futures.

Source: Bloomberg, Mount Lucas

Interestingly, at least to us, is the reason why. Managed Futures tend to have commodity exposures, fixed income exposures and currency exposures. Some do stock as well. All instruments that tend to shift with the macroeconomic uncertainty. They don’t tend to do individual stock or credit picking, these are large global macro markets. Inflation impacts all of these. Commodity prices up in the first part of the year helped a lot – oil markets and grains. Short positions in fixed income as bond yields rose across the globe. Currencies are maybe the most direct expression of macro and were large contributors. The Euro fell hard driven by relative interest rates and growth trajectory impact due to proximity to the geopolitical situation. The Bank of Japan continues to maintain ultra loose monetary policy settings through a 25bp 10-year yield curve control policy at a time when the US is raising the front end by 75bps every meeting. The Japanese Yen moves abruptly lower. We show a few of these market moves in the postscript below. Managed Futures has exposure to each of these moves. The uncertainty hurts equity markets, Managed Futures diversifies uncertainty.

So where do we stand now. Well one reason you do different things in a portfolio is that when one set of things is struggling and another is doing well, you can rebalance along the way. Use the gains in Managed Futures to buy stocks and credits when they are more reasonably valued. 2008 was a great example – stocks fell 37%, CTAs had great years. The years after were reversed, with stocks making 26% in 2009. Rebalancing the CTA gains meant one could use the gains to buy equity at lower levels. One has to decide the timing – truth be told it doesn’t matter too much, as long as you do it. Annual maybe a little too infrequent, quarterly or monthly seems about right to us. And if they haven’t moved a lot relative to each other, maybe it’s not worth it and a rebalance threshold approach is more reasonable. That’s fine too. Examples of what this would look like are below – monthly schedule when they have moved a chunk. Rebalancing the CTA as it goes up, and buying equity like clockwork. No fuss, no panic.

Source: Bloomberg, Mount Lucas

If you don’t have exposure to Managed Futures in a portfolio, maybe consider if it makes sense as a way to get exposure to a different return stream that often benefits from uncertainty, in a way that fits your goals. If you already do have exposure and it has performed well while other things haven’t, and the allocation has naturally grown through those performance differences, consider rebalancing. Now timing this is next to impossible. But picking a time, rebalancing mechanically like clockwork is important. If you have a good portfolio plan, follow it.


Below are examples of moves that have worked in Japanese Yen, Crude Oil and US 10YR Notes, respectively.

Source: Bloomberg, Mount Lucas
Source: Bloomberg, Mount Lucas
Source: Bloomberg, Mount Lucas

As We See It: Quadrants

The idea of investing quadrants has been around a long time. Divide the potential environment into 2 planes, basically growth and inflation. Determine the current intersecting box, invest in the things that have done well historically in that box. It’s a great shorthand method of putting order to chaos, most of the time. Thought experiment … Is the economy growing? Real GDP is negative, so no, nominal GDP is on fire, so yes. Weekly unemployment claims are low, so yes, but job openings are falling, so no. You get the point – picking the box is tough. We are in a really inflationary time, so buy gold, right? Wrong, regardless of what the cable ads say.

Check out this chart:

Earnings expectations have fallen, particularly ex-energy, as the market factors in a recession. Strange recession where energy companies are the leader.

We prefer to let price be the guide. It’s no surprise that when researchers looked at a vast array of possible variables that drive AI investment decisions, momentum clearly dominated all other choices (OP-REVF200009 ( Our preferred method is trend-following. If you boil it down, trend-following is simply a robust method of identifying an unobservable state variable (fancy, huh). Am I in a bull world or a bear world, across a wide range of markets. It’s not locked into a pre-defined set of relationships. An overused quip is of use here – history doesn’t repeat, but it rhymes. Use trend to get the beat.

As We See It: The UK Bond Debacle

Same tune, different words. Every. Single. Time.

Some big pool of money (BPM) would like something for nothing. Large financial institutions (LFI) are happy to help. Heck, they even compete to help the most. As long as X never happens – and of course it never does – we can give you exactly what you want. In the 1980s, pension funds wanted to be long stocks but not the downside tail. Buying puts was too expensive. No problem says LFI! We will give you something called portfolio insurance. Instead of paying implied volatility, you can own an option-like structure at realized volatility. As long as the market does not gap down a lot – which of course it never does – there is plenty of liquidity to execute the hedge. October 1987 put an end to that little fantasy. Then there were those good old sub-prime loans. Some BPM would like some higher yielding debt. No problem says LFI! Each mortgage may be risky, but they are much better behaved when we look at a big basket of them and we’ll spread them out all over the country. As long as house prices never go down, which of course they don’t, and certainly not all over the country, these bonds are golden. We’ve even paid someone to give them a AAA rating! That ended…not well.

The current situation. UK pension funds (BPM in this case) have a problem. On paper, falling interest rates lower the discount rate on the future liabilities of the fund. Makes the fund look bad. Can’t have that, say LFI. We will buy a leveraged position of long duration bonds. As rates fall, the increase in liabilities will be offset by gains in the long bond portfolio. If rates begin the rise, the losses on bonds will be offset by paper gains in the reduced liabilities. Sounds good, or as Dire Straits crooned…Money for Nothin. This will work fine, as long as we don’t get a real fast inflationary spike in rates, which of course we won’t because we know inflation is dead. Whoops…

Source: Bloomberg

Rates spike, liabilities do fall on paper, but the margin call on the bond long requires real money…right now. A classic liquidity mismatch. All of a sudden, pension funds have a margin call. On this latest yield spike, the central bank has to intervene in the name of financial stability. Liquidations spread to other markets as the funds scramble for cash. Normally history doesn’t repeat exactly, but rhymes. In this instance though, it’s closer to a straight rerun. This happened in Orange County, CA in 1994 when rates rose, and it’s literally used as a finance case study on risk management and what not to do. And yet here we are, just far enough along for a new generation to make the same mistake.

Rule 1 in finance…keep it simple.

Postscript – October 11, 2022

The FT has published a fabulous piece on the episode at this link (paywall). It fills in the BPM and LFI cast of characters and has some great quotes – turns out our read was pretty accurate all told…

As they made their pitch to overhaul the pension scheme of one of Britain’s biggest retailers, Next chief executive Lord Simon Wolfson remembers the consultants were “very sure of themselves”.

“Liability-driven investing”, the consultants promised, was a stress-free way to protect the fund from swings in interest rates by using derivatives.

There is one particular phrase that still sticks in Wolfson’s mind from the 2017 meeting: “You put it in a drawer, lock the drawer and forget about it.”

“The speed and the scale of the move in the gilts market was unprecedented,”

“The crunch event was not in anyone’s models,”

But even he acknowledges that its complexity is an issue, with tricky collateral management and an orchestra of instruments from gilt total return swaps to gilt repo and inflation swaps. “Undoubtedly the problem is that people don’t really understand it,” he said. “It’s like trying to explain some aspects of quantum physics to people who aren’t really physicists.”

…pension schemes in aggregate will have to come up with as much as £280bn to fully recapitalise their interest rate and inflation hedges with new lower levels of leverage. This is in addition to the £200bn that schemes have already had to deliver to meet LDI collateral calls…

As We See It: Everything Selloff, But…

When you woke up yesterday morning, this was the headline of the lead story on Bloomberg News:


The past week had been really tough, with bonds and stocks both crushed, regardless of locale. There were panic moves everywhere, but particularly in sterling. Third world type emergency action being considered to control the slide. If the Fed’s mission was to break something, well, mission accomplished. Negative skew everywhere. There was, almost, no place to hide.

Almost because there was one place to hide, a well known asset class that advertises success in periods of adversity and volatility. An asset class that exhibits positive skew, or as my partner likes to say, it crashes up. An asset class that is up this year, and up this month, yet is not particularly dependent on manager skill. Simple Alternative Beta indexes capture the returns nicely. Its liquid and easy to access in a variety of formats.

What is it, you say? Its Managed Futures, of course. Now let me warn you. There will come a point when the markets will settle down, Darth Powell will take his foot off the brake, and traditional assets will recover. Managed futures will likely give back some recent gains, perhaps with a vengeance. But if you had it in your portfolio, the profits you gained could have been rebalanced into those cheap equities and credits, primed for the next move higher. It’s a beautiful thing, but you need to be in the game to win.

Managed Futures In The Portfolio

The last few months have been a fantastic case for the role of managed futures in a portfolio. Managed futures do well in periods of macro volatility, and this time is no different. What investment, that can be measured passively, has done well this year? Short term treasuries? Nope. The Bloomberg US Treasury 1-3 Year Index is down 1.5% YTD (through Feb 14, 2022). Stocks? Nope, the S&P 500 TR Index is down 7.5% and the Nasdaq-100 TR Index is down 12.5%. Real Estate? The Real Estate Select Sector TR Index is down 13.2% YTD. Some of the tail risk and long vol strategies were also down. How about managed futures? The MLM Index EV (15V) is up 10.3% YTD. So why is it that managed futures have not gained wider acceptance as a portfolio element? There is a lot of blame to go around. Let’s have a look.

All the issues around managed futures arise from the character of the returns. Managed futures have positive skew, the profile of an option buyer. Lots of small losses (like premium paid), with occasional big gains. This is the reverse of the stock market, where the market goes up in small steps and down in a whoosh (negative skew). The attraction to managed futures is that the big gains are often at the same time as the stock market whoosh, like this year, and that they can capture that convexity whether it’s being driven by market moves up or down. Risk parity models try a similar approach – using bonds to diversify stocks, but that only holds when bonds go up. Sometimes its bonds falling that cause the equity whooshes. Sound familiar? Being able to generate convexity on both sides is a big improvement. The character of managed futures returns breeds a lot of behavioral biases on the part of investors. But first, let’s look at the managers.

First, the fees are too high. In its infancy managed futures was sold as a pure skill game (not unlike stock picking prior to some ground-breaking research in the 60s and 70s). Pure skill demands a high price. Index funds, then passive ETFs, entered the equity space and reduced the price for market beta dramatically. Think of it this way – if we pay a high fee for the investment, it increases the premium of the synthetic option we buy with the investment. If we pay high fees waiting around for the investment to pay off, the cost will consume the return. In options lingo, high fees are akin to high theta bleed. Keep the fees down and the outcomes will be better. Index funds are entering the managed futures space now. You shouldn’t pay high fees for beta anywhere, that holds for managed futures as well. The academic research supports this – you can read more here.

Investors love negative skew. They shouldn’t, but the siren song is too much. They love making money most months. Advisors love negative skew. Nothing to explain except in the months where everyone gets whacked. Investors hate looking at the lineup of their investments and see this thing that has been leaking a bit while the stock market has gone up. Advisors take the plunge in managed futures AFTER a big run, when the odds of losing are actually greater. We all look at our financial situation holistically, look at the entire picture. We are unlikely to go through life without homeowners’ insurance, a classic positive skew product. And we would be foolish to buy it after the house burnt down. It would be imprudent to pay a high premium as well. Can you imagine if you looked at your financial situation once a month and said, “this stupid insurance costs me every month, I am going to cancel it”. Managed futures is properly viewed as insurance against macro volatility. Granted, it does not have the contractual nature of true insurance, but it has the same positive skew. When managed futures pays off, like this year, rebalance – rebuild the house. Use those gains to buy cheap stocks. Pump the volatility of your portfolio elements.

Managers over the years have tried to overcome the reluctance to invest in managed futures by improving the Sharpe ratio of the investment. This is generally done in one of two ways. The first to us is a cardinal sin – using that spare cash available to managed futures strategies to try and eke out a few extra basis points in supposedly safe credit pools that turn out not so safe. This is potentially selling away all the positive skew benefits for incremental fractions of pennies on the dollar. Don’t do this, know what you own. The second way is typically achieved by reducing exposure when volatility increases. The direct result of this decision is a truncation of the skew of the return distribution. It may be a good decision for the manager’s business, but it is terrible for the investor. When volatility rises, that is exactly when you want more managed futures exposure, not less. Think about it – your long only traditional investments are seeing bigger price fluctuations, you need your diversifying portfolio elements to show up, not be shrinking away. It is akin to your insurance company reducing your coverage level as the wind picks up. You need to keep the potential payout high. Sure, the drawdown on the other side may be larger, but the increased return in the heat of the moment allowed you to hold your negative skew investments and rebalance into the recovery. We’ve written some more details on this phenomenon here.

Managed futures checklist: Keep the cost down. Maximize positive skew. Rebalance aggressively.

Index Descriptions: The Bloomberg US Treasury: 1-3 Year Index measure US dollar-denominated, fixed-rate, nominal debt issued by the US Treasury with 1-2.999 years to maturity. Treasury bills are excluded by the maturity constraint, but are part of a separate short Treasury Index. STRIPS are excluded from the index because their inclusion would result in double counting. The S&P 500 index is an unmanaged index consisting of 500 stocks chosen by the Index Committee of the Standard and Poor’s Corporation that generally represents the Large Cap sector of the U.S. stock market. Returns for the S&P 500 index reflect the reinvestment of all dividends. The Nasdaq-100 is a stock market index made up of 101 equity securities issued by 100 of the largest non-financial companies listed on the Nasdaq stock market. It is a modified capitalization-weighted index. The Real Estate Select Sector TR Index is a subindex of the S&P 500. The Index seeks to provide an effective representation of the real estate sector of the S&P 500 Index and seeks to provide precise exposure to companies from real estate management and development and REITs, excluding mortgage REITs. The MLM Index EV (15V) “Index” serves as a price-based benchmark for evaluating returns available to investors in the futures markets. The Index applies a pure systematic trend following algorithm across a diversified portfolio of 11 commodity, 6 currency, and 5 global bond future markets. All data is through February 14, 2022.

You Can Eat Or You Can Sleep

“You can eat or you can sleep”. The biggest change I have witnessed over the course of the past 3+ decades is the change in investor preference, particularly hedge fund investors, away from positive skew to negative skew… from sleeping to eating. I sleep well. The quote came from a discussion my partner had with another manager who runs a fund that is often aggressively short volatility. He, like all of Wall Street and beyond, have monetized this preference for negative skew – regular returns most of the time, with the occasional blowup. They are eating well.

The preference for negative skew flies in the face of conventional finance theory and behavioral economics. After all, why would people buy lottery tickets? Smarter people than me have worked these ideas over, and it’s a bit of a mess. Let’s just think about 3 possible drivers (I am not bashful about stealing others good ideas). Some of these thoughts are motivated by a great blog post that can be found here:

  1. Falling Yields. Investors will give up positive skew in return for higher yields. In a low rate environment, one can get a higher yield by selling options. The last 25 years have seen persistently lower yields, and a wildly expanding options playground. Man wants a green suit, turn on the green light. Build product that yields well but has negative skew.
  2. Moral Hazard – that thing officials used to worry about. No more. The central banks of the world, and, increasingly, the folks at the controls of fiscal policy, all but guarantee the financial downside. A hedge fund / family office that exploded earlier this year drew only fleeting notice from officialdom. Why? Because it was a garden variety bad trade, housed at one particular fund. There was nothing systemic about it … because it was a positive skew position. It was a classic one-off. Importantly, at the end of the day, they knew what he could lose. Systemic option selling has unlimited downside, and the players will not let that happen. Investors have grown to rely on this protection and have piled in – moral hazard.
  3. Principal/Agent. No one likes to be told they have lost money. Agents know this. They also know that if they have company, it goes down easier with the principal. Join the crowd and count on number 2 above. Early in my career, we were trying to interest a large consultant in our fund. He listened politely, but at the end of the day he said that he was investing in a mortgage fund that made money every month. The meeting ended (as I recall we took him to dinner and a ballgame… I still regret it). That fund blew up a few months later in the first of the many mortgage meltdowns. He survived… in fact sold the consulting firm to a private equity shop. Eating well.

Contrary to these changes in preference, we have no intention of changing our stripes. We understand that our style is a more difficult hold than a steady earning, negative skew manager – that’s why there are very few of us left. But in a portfolio context, there is real value in a strategy that pushes against the prevailing wisdom. And we have demonstrated, over 3+ decades, that we can sleep well.

What Did Skew Do for You?

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.

You Shouldn’t Bring a Knife to a Gunfight!

Stocks and credits are negatively skewed and historically have had large drawdowns. Neither asset class is volatility adjusted. If you are optimizing for the whole, and are rebalancing, you ideally need diversifying assets that have a negative or low correlation and positive skew.

Source: Mount Lucas and Evestment

Below we compare the MLM Index EV and MLM Global Index EV to the SG Trend Index (index of manager returns) and the CS Liquid Managed Futures Index (vol-adjusted price based index) and show skew and correlation statistics. Note the crisis returns are materially higher, our indices have the highest skew and kurtosis – which pairs most advantageously with stocks and credit that are negatively skewed with high kurtosis.

Source: Mount Lucas and Evestment

Correlations below as well.

Source: Mount Lucas and Evestment

Practical Examples

Cast your mind back to late 2008 into 2009 when things were really going wrong. Stocks were plummeting, credit markets were freezing. At the same time, the USD was going up, crude oil was dropping precipitously, and the US Treasury market was rallying. See the impact at the position level of a representative model that vol adjusts vs our trend following approach, using the Nasdaq as the example.

Source: Mount Lucas

Volatility adjusting positions reduces the diversification benefit at the worst time. The Nasdaq began to fall, the trend following component of the models moved short. The volatility adjustment process reduces the short as realized volatility picks up on the down move around the Lehman collapse. In this representative example, the short is reduced by some 60%.

In the next chart we compare the volatility adjusted model to the unadjusted model, you can see the unadjusted volatility approach has higher returns when you need them most. When using this approach, it is critically important that that portfolio elements are rebalanced. Even though returns in this example end up in about the same spot, at the portfolio level the sequence matters. The extra gains are monetized, the Managed Futures allocation is sold down, and more stock is bought at lower levels.

Source: Mount Lucas

Volatility adjusting can also be detrimental, given that equity prices and vol are negatively correlated. In early 2018, volatility collapsed until it didn’t. As volatility adjusting models increased position sizes in response to falling realized volatility, they are making the case that risk is falling, which is dangerous in our view. When the market fell and fell quickly, they took larger losses as they were at max positions. In a portfolio context this reduces the portfolio diversification benefit to the investor, particularly when this is applied to equity index markets.

A Better Portfolio

When modeling a portfolio with stocks and credits, the different approach is clear. In the example below, we start with a portfolio that holds 50% each stocks and credit. Then we add some vol-adjusted managed futures and some leverage to create a portfolio with 40% stocks, 40% credit, and 60% in CS Liquid Managed Futures. For the last two portfolios, we swap in the MLM Global Index EV and the MLM Index EV at the same 60% allocation for managed futures.

Source: Mount Lucas and Evestment
Source: Mount Lucas and Evestment

Note the skew changes at the portfolio level – typical portfolios are negatively skewed, and adding an uncorrelated positively skewed strategy takes the overall portfolio to zero skew. Drawdowns are much reduced, portfolio Sharpe ratio increases, overall portfolio volatility goes down.


The Covid crisis (Jan 2020 to Mar 2020) provides a complete example in a compact period. Typical trend managers were very long equity December through February, as volatility was still quite low. When markets broke, volatility increased and the exposure of the trend shorts was proportionately reduced. The same was true in other markets like energy. The MLM Index approach, using constant exposure and thus increased skew, provided better returns over this difficult period. If its diversification you want, ignore the siren song of Sharpe, and go for the skew.

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.