Executive summary

Much has been made recently of crisis alpha or crisis risk offset. And, in particular, of using trend following as a hedge of future downside moves in, mostly, equity markets. We demonstrate that trend following is mechanically convex relative to the underlying upon which one is trending, but, that the overall convexity offered by CTAs is mitigated by implementation steps that improve risk and execution cost adjusted returns. Trend Following should primarily be viewed as a highly statistically significant strategy, while the existence of convexity, albeit weak, should be considered a bonus feature to an investment in Trend Following.

Introduction

Commodity Trading Advisors (CTAs) have traded futures markets for many years using, on aggregate, an approach exploiting the persistence of trends in prices. It has been demonstrated by many, the current authors included, that following trends is a profitable strategy with a high level of statistical significance. The Sharpe ratios observed by a systematic approach are modest, as are the returns of the industry. These modest Sharpe ratios are, however, persistent – leading to the conclusion that the approach represents one of a growing number of alternative benchmark strategies upon which the alternative beta industry has been created.

However, traditional benchmarks still reign supreme, with equity indices composed of developed markets and/or emerging markets mixed in with both sovereign and corporate fixed income type return streams representing the backbone of most institutional investment portfolios. These investments are sound, with expected Sharpe ratios in the range of 0.3-0.4 for equities and, to first order, the excess yield of developed market sovereign bonds leading to low Sharpe ratios in low interest rate regimes. The advent of the Alternative Beta industry has spurned interest in an alternative, decorrelated (and hopefully positive) return stream that can potentially help to decrease the volatility and drawdowns of investor portfolios.

Trend following, in particular, is an alternative benchmark strategy that exhibits certain features that help traditional portfolios. This was most strikingly illustrated through the Global Financial Crisis of 2008 when most traditional and alternative strategies sold off. The CTA industry, which, frankly speaking, until 2008 only occupied a sleepy corner of the Hedge Fund world, revealed itself to be one of the strategies that performed best during stressed markets. The SG CTA index was up 13.1% through the tumultuous financial crisis period of 2008 while many CTA managers recorded multiple returns of 3-4 standard deviations (or annualised volatility) for 2008. This obviously attracted a lot of investor attention and the CTA industry picked up the pieces from the crisis to become a prominent sector of the Hedge Fund universe.

The returns that followed the crisis from 2009-2013 disappointed many. Having invested on the back of reasonable returns over several economic cycles and spectacular performance in 2008, clients began to deliberate on the death of the trend in an overcrowded market, leading, ultimately, to a modest pullback from the industry globally. That this effect predated the dramatic 2014 draw-up in CTA performance is testament to investors’ preponderance for following trends. All of a sudden CTAs were back in vogue, and investors and analysts began to give the industry a second look – in essence following the trend of trend following performance.

We begin our discussion of trend convexity by setting the scene with a mathematical framework. The less mathematically minded reader is encouraged to skip this section and move onto a discussion of our key equation that shows that trend following is mechanically convex relative to the instrument being trended upon. There are various additional techniques involved in building a CTA, however, and these can reduce the convex nature of the trend following strategy. Techniques such as: (i) trending on a diversified pool of instruments; (ii) imposing a maximum (a cap) on the trend forecast and, finally, (iii) slowing the strategy down such that it reacts only gradually to sudden underlying moves. We finish our discussion with a convexity study of the Société Générale (SG) CTA index that shows how much protection the CTA industry really provides. We conclude with a summary of our results.