After two years of disappointing performance in 2011 and 2012, trend following strategies – more often called trend followeror more generically managed futures – which offer ultra-diversified exposure to global financial markets – experienced mixed fortunes in 2013.
The relatively weak performance in 2013 of an index representative of trend follower such as the Newedge Trend Index (2.67%), is likely to reinforce the resentment within part of the investment community with regard to these strategies.
Models unsuited to the market paradigm that appeared with the crisis, broken engines or strategies belonging to the past. The criticisms that the trend follower had their heyday, but would no longer have a place in the portfolio allocations today.
But as often, the reality is more nuanced. If the indices following the trend follower struggled to generate a positive performance in 2013, this result is also accompanied by a greater dispersion than usual in the performance of the funds tracked by these indices. Some even recorded unprecedented gains, like the performance of more than 16% achieved by the Epsilon strategy managed by Lyxor Asset Management teams. Also, in many respects, 2013 cannot be reduced to another year marking the decline of trend follower. On the contrary, it rather augurs a revival for these strategies, among the oldest in the universe of hedge funds.
A systematic investment approach for unrivaled diversification
In order to better understand the origin of the difficulties encountered by trend follower in recent years, a brief reminder of the founding principles of these strategies is in order. While traditional management relies on a qualitative or quantitative analysis of asset price levels, trend follower take positions in the markets solely on the basis of price momentum, regardless of the intrinsic valuation of the assets.
A secular phenomenon in the markets, trends are the result of inefficiencies that find their source in elements such as the difficulties of certain investors to rebalance their portfolio, or even the herd behavior of the markets. They also lend themselves well to a systematic investment approach, which allows them to be identified with a view to taking a financial position.
By fixing the statistical characteristics of each market’s behavior (e.g. volatility, correlation, average return, probability of experiencing a jump in price level, etc.) that may indicate a trend, trend follower managers can free from the fundamental approach. Such a systematic approach, which does not require fundamental knowledge of each market, allows them to simultaneously expose the portfolio to a large number of markets. The result is an investment strategy with an unequaled degree of diversification, capable of generating performance in both bearish and bullish market environments – if the trends are there.
Decorrelated but disappointing performances in 2011 and 2012
Why did the situation get out of control in 2011 and 2012, resulting in disappointing poor performance for investors? Before answering this question, it should be remembered that the trend follower have already experienced difficult years in the past. In 2003 and 2004, at the end of the cycle of falling interest rates putting the bond markets under pressure, an environment characterized by weak trends and a clear rise in correlations between the markets had penalized the effectiveness of the models. The impact on performance had been felt less harshly, thanks to monetary rates – at which the asset of a trend follower – significantly higher than today.
Performance of trend following, international equities and international bonds (January 2000 – January 2014)
A higher yield than stocks for a much lower drawdown
In 2011 and 2012, market developments boiled down to a series of risk on/risk off movements closely dictated by the succession of plans aimed at stabilizing the international financial system. By punctuating the alternation between periods of flight towards safe-haven assets (sovereign debt, gold, silver) and those of repositioning on risky assets (equities, emerging markets, commodities, currencies), political interventions have invalidated a number of trends identified by the statistical models of the trend follower. They will also have put all the markets in tune, which were only responding to one factor, that of political intervention.
At the same time, this simultaneous evolution of all the markets considerably reduced the effectiveness of a classic risk allocation strategy.
A basic principle of trend-following funds is to take a position in a large number of markets by spreading the risk equally across all markets without proper consideration of correlation. However, this simplified approach to diversification seems to have reached its limits in 2011 and 2012.
Trend indices and correlation
A normalization of the markets which is illustrated by a return of trends and a lower correlation
If the criticism of trend follower was built on the reality of a trendless market environment marked by strong interventionism from the monetary authorities, the asset class has probably also suffered in comparison with other lower volatility strategies, including those playing the bond recovery. Yet the
trend follower retain all their appeal, first and foremost their strong decorrelating power, which has never been denied since 2001.
Annual correlation of trend followers with major asset classes, 2000-2013
On average, trend followers are characterized by a low correlation with the main asset classes
Normalization of markets in 2013
As illustrated by graph 2 on the trend and correlation indices, the agreement on banking union signed in autumn 2012 started the fall in correlations and breathed new life into trend follower. These also performed well until May 22, 2013 and the announcement of the imminent reduction of the Federal Reserve’s bond buyback program. The turn of the debates relating to the US federal budget then plunged the markets back into a period of uncertainty, which resulted in an immediate resurgence of the risk on/risk off environment until an agreement was reached in Congress. in extremis in the fall. This extension of the period of transition to a new monetary policy regime explains the heterogeneous performance of CTA funds in 2013, due to the difficulty of grasping trends in a still unclear environment.
Initiated at the end of December, the reduction in monetary support for the American economy now confirms the hypothesis that the specter of a systemic crisis is distancing and with it the risk on/risk off movements that are detrimental to managed futures strategies.
The trump card of risk allocation
Examination of the behavior of trend following strategies in an environment marked by exceptional levels of correlation between markets, where there is only one factor that comes into play, as was the case over the period 2008-2012, reveals areas for improvement to work on. Unlike 2008, when the continued development of bullish trends in gold and commodities allowed the models to demonstrate their full relevance, the absence of trends cut off their oxygen in 2011-2012. This episode forces reflection on the identification of market regimes.
The quality of the statistical models making it possible to identify a market trend constitutes the starting point of a
trend follower. The high correlations in 2011 and 2012 will have highlighted the importance of the allocation model, whose ability to adequately diversify a portfolio is the sine qua non condition for the success of a trend follower over a long period covering different market regimes.
An allocation of risks managed by a model and based solely on the know-how and experience of the teams is not sufficient. Formalizing risk allocation issues provides a more documented view of the impact of a position on the total risk of the portfolio.
It is in this spirit that Lyxor’s research teams have been advancing since 2011. An alternative allocation model was put into production in September 2012, after proving conclusive over the nine months during which it was tested in simulation. For Lyxor, determined to maintain a medium to long-term trend-follower strategy where other trend-following funds allow themselves to vary their approach from time to time, this new allocation model gives greater robustness to the management.
A deserved place in asset allocation
A number of players in the collective management industry, traditional and alternative, have already taken the measure of the issues associated with risk allocation a few years ago. For trend-monitoring managers, integrating this issue takes on a strategic dimension. The challenge is none other than to reinforce the comparative advantages that this strategy has over other asset classes over a long-term horizon.
Indeed, over the long term, managed futures already show a higher return/risk ratio than most other risky asset classes. They are also distinguished by their decorrelation from major market indices, which makes them one of the most effective instruments of alternative management today.
For example, unlike long/short funds, whose performance includes, depending on the strategy, an equity, credit or bond component, trend followers do not have a structural relationship with a particular market. This decorrelation can be detrimental, especially during periods of strong market rises, when trend followers will show underperformance. But it has its advantages. When strong downward trends appear, as was the case in 2008, trend followers have, unlike other alternative strategies, done well.
Performance of alternative strategies indices since 2000
Relatively stable performance over the long term
The performance distribution of hedge funds differs from that of trend follower which have a positive skew. When they fall, the losses come out much smaller than the volatility of the strategy would suggest. And if they often lose a little, they go up sharply when they win.
The introduction of trend following strategies within a traditional portfolio reveals all the benefits of diversification.
Thus, as one would expect from the addition of a decorrelated asset class within a portfolio, the mean-variance analysis of the performance of a portfolio made up of equities and international bonds to which we would add an allocation to a trend following strategy generates a more efficient portfolio since it is more diversified. This positive observation is likely to justify an unprejudiced examination of the contribution of trend following strategies when defining the investment strategy.
Efficient frontier of a portfolio of three assets
The trend following improves the efficient frontier