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.
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.
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.