Making Fat Right Tails Fatter With Trend Following…

Most of the time

Capital Fund Management LLP

Executive summary

Our prior work has demonstrated the mechanically convex behaviour of trend following that many in the investment industry have enthusiastically embraced as a possible protector of asset portfolios. In this short paper we develop and explain the consequences of these ideas in terms of how this convexity leads to a positively skewed returning strategy, which in turn then becomes a performance chaser’s nightmare – selling after prolonged periods of inevitable disappointing performance before missing the next, unpredictable acceleration in positive performance. We contrast this with the P&Ls of most other strategies and assets that are predominantly negatively skewed. This opposing return pattern lures investors into a false sense of security and is equally dangerous to performance chasers. We argue that trend following should form a core and stably allocated component alongside traditional assets in a diversified portfolio. Performance chasers: beware!

Introduction

Many probing questions have historically been asked about trend following and its longevity as a strategy. Many more probing questions were asked after most Commodity Trading Advisors (CTAs) – firms that predominantly exploit trend following strategies [1] – failed to ‘protect’ against the abrupt, and severe market sell-off in February earlier this year. [2] The efficacy of trend following as an anti-correlated strategy to equities, and, as it is often marketed, a protective [3] addition to a portfolio are some of the key qualities often espoused by trend managers. Trend followers on aggregate did, however, not live up to this misplaced expectation in February, when markets sold off and implied volatility went through the roof. The two most widely quoted CTA performance benchmarks, the Société Générale CTA (NEIXCTA) and BarclayHedge CTA (BARCCTA) indices fell by 6.3% and 3.7% respectively during February. [4] The S&P 500 meanwhile lost a ‘mere’ 3.9%.

Trend following strategies, in times of severe, instantaneous market jumps or corrections, have a 50% chance of being on the right or wrong side of a large market move. No trend following program could for instance have protected against the 8.7% tumble in the S&P 500 registered over the six trading days that started on Friday, February 2. Even the fastest trend signals would have been unable to react quickly enough to have profited from the downside move. Trend following, as such, is much more adept at providing uncorrelated protection in a long and drawn out bear market (also providing protection from a long and drawn out bull market!)

Speculation as to the apparent failure of trend following strategies is rife. Some observers ask whether trend following is ‘dead’, [5] while others claim that a new regime of higher volatility and a directionless environment will spell doom for trend followers. Some worry that trend followers have become too correlated with equities (offsetting its anti-correlated properties), while others have asserted that trend was killed by the large quantitative easing (QE) experiment of central banks, and that a rising interest rate environment will prove problematic. [6] It is worth noting that trend followers inherently do not hold, nor position a strategy on any discernible macroeconomic information.

It was, despite the mounting chorus of negative rhetoric, not so long ago that trend followers were considered the darlings of the alternative industry when CTAs outperformed during the 2008 financial crisis, surfing the downward trend in stocks, and the rally in bonds. The crisis revealed that money managers on the whole were exposed to an uncorrelated set of risk premia in normal times, only to become correlated in the heat of the crisis. Trend following proved itself to be an outlier in offering good returns (and liquidity) in a period of market stress.

One may nevertheless forgive the not-so-dyed-in-the-wool trend advocates of questioning the efficacy of trend following as a complimentary, alpha generating addition to a portfolio. Investors, one may rightly argue, are reasonable in rethinking their commitment to trend following, and/or hesitant to invest in a strategy that seemingly fails to protect against a sell-off, and moreover, has registered lacklustre performance since 2015. Yet, trend following strategies have remained popular with consistent inflows of nearly 15% average per annum since 2000. This growth may of course lead investors to question whether the space has become ‘crowded’.

We acknowledge many investors’ anxieties with the recent performance of trend following, along with the concerns about its protective properties, a crowded space, and correlation magnification. We nevertheless consistently champion the idea that trend following is a long term, diversifying strategy that is highly statistically significant, not overly sensitive to trading costs and takes advantage of one of the classic behavioural biases – that of the human propensity to follow trends. We furthermore believe it is in the best interest of any investor to remain invested, and not attempt to try and time entry and/or exit decisions. Investors and asset managers alike grapple with timing decisions, looking for spurious signals that may indicate an opportune time to either invest, or redeem from a strategy. Basing a decision on noisy price signals to enter or exit a position is fraught with difficulty, as we will explain below.

Convexity and skewness: a recap

Trend following has been shown to exhibit unique convexity features that are mechanically stable over timescales comparable to that used for the trend. Key to understanding why investors should proceed with caution when (or if) deciding to change their allocation to trend following is to understand the origin of the convexity and the ‘positive skewness’ that it produces. We have written extensively on the concept of convexity, [7] and while this paper is not intended to rehash nor expand on what has been well-covered before by ourselves and others, it is worth recapping what these stylised facts are, and tease out why these features are central to the danger of any attempt to time trend following.

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