This article was co-authored by Alan Dunne with Niels Kaastrup-Larsen of Top Traders Unplugged and Dunn Capital for HedgeNordic.com .
2022 was in some ways a reminder of why Managed Futures strategies, particularly Trend Following became known as Crisis Alpha strategies. The SG Trend Index was up 27% while both bonds and equities suffered double digit losses.
The term “Crisis Alpha” was coined by Kathryn Kaminski following the Global Financial Crisis in 2008, in response to a question by a big pension fund wanting to understand why Managed Futures did well during the crisis. This was an exciting development for our industry as suddenly we had a simple term to describe one of the most desirable features of Trend Following, a term with the added benefit of being so simple that analysts could remember it and repeat it during investment committee meetings.
After a successful adoption of the term Crisis Alpha, and the resulting inflow of institutional capital to our industry, it became clear, that perhaps it was too good to be true. Many managers, found themselves explaining why their “Crisis Alpha” strategies did not perform well during the periods when equity markets wobbled, culminating in “Volmageddon” in February 2018, when stocks sold off sharply over a two-week period and CTAs also had drawdowns. In many respects, this was probably the turning point for many investors, who simple lost patience and the belief that Managed Futures or Trend Following would deliver the return profile they had been “promised”; redemptions from the industry gathered pace.
What Does Crisis Alpha Really Mean?
But in the last couple weeks, as part of a series of conversations with the largest CTAs on the TopTradersUnplugged Podcast, we caught up with Kathryn Kaminski to revisit “Crisis Alpha” and it seems that it may have gotten lost in translation.
As Katy explained… the original question was: “what is it that makes a strategy succeed during stress?”
Well, there are a few features. Number one: liquidity; number two: it has to be opportunistic and number three: it should have No bias.
First, liquidity is important because if you have liquid strategies, when things are difficult, you can reposition your portfolio quickly and efficiently.
Second, if you have a strategy that is opportunistic, it means you can be long and short different markets depending on the opportunity set. For example, during COVID, the best trade was to short energy and long bonds while during the Ukraine/Inflation crisis, it was the opposite.
And lack of bias is extremely important. Trend Followers had been riding the long bond trade for a long time and very successfully. But in the aftermath of the COVID crisis, when it became evident from the price action that bond yields had seen their low and prices started to fall, Trend Following strategies (unemotionally) went short and capitalized on the bond bear market.
So, as we bring back “Crisis Alpha” in our narrative and conversations with investors, we should remind them that it is a simple term that is there to help our understanding of which strategies have the potential to perform during stressful periods and their characteristics. Trend Following and Managed Futures are some of a small set of strategies that have characteristics (liquid, opportunistic and unbiased), which give them the potential to generate Crisis Alpha.
How Important is Crisis Alpha for CTAs?
The discussion around Crisis Alpha, and how Managed Futures can deliver it, has been back to the fore, ever since Cliff Asness wrote a paper last year called “The Raisons d’être of Managed Futures”.
In the paper, Asness argued that some Trend Following, and Managed Futures managers may be moving away from what he called the implicit dual mandates of:
(1) delivering positive returns on average; and
(2) generating especially attractive returns during large equity drawdowns (i.e. Crisis Alpha).
Using data from the SG Trend Index, the paper highlighted that in the last 13 years trend followers had appeared to be successful in delivering on mandate 1 but less successful in delivering on mandate 2. Notwithstanding some methodological issues with the paper, such as the fact that the composition of the SG Trend index has shifted over time, Asness was raising a reasonable question:
Have many of the largest trend followers become more focused on delivering more consistent returns and a higher Sharpe ratio and less on delivering crisis alpha?
We were naturally keen to get the perspective of other managers in the SG CTA index when we spoke to them. The consensus that emerged was that while most large CTAs aim to produce the typical return characteristics of Managed Futures (positive returns over time, low correlation to equities, positive performance in equity drawdowns etc.) they were first and foremost aiming to generate absolute returns as “consistently” as possible. Positive performance in equity drawdowns was seen as a favourable characteristic, probably not an explicit part of the mandate, but perhaps something which has evolved to become a secondary part of the mandate.
The sentiment was summed up nicely by Russell Korgaonkar, CIO at Man AHL:
“I think trend followers going into 2008 didn’t consider in particular performance during negative equity markets. I think they thought here is a system that tends to work, it tends to have nice return properties and that was the focus. I think if you talk to most institutional investors they care about both. Clearly, they care about the returns, but they also do care about the Crisis Alpha or being generally diversifying… It’s one of those things it was never the original intention, but as time has gone one and perhaps as what people value has changed, it has become part of the lexicon.”
In that regard, a key point raised by many managers has been the challenge of staying true to a pure Trend Following approach, given the difficulty investors experience in staying invested in a pure Trend Following program over the long term.
When we spoke with Marty Lueck of Aspect he described how Aspect Capital approach this:
“We offer Trend in a number of different formats. The motivation for that is the passionate belief that the trend utility is so useful in investors’ portfolio … trend is the medicine that is good for investors, and all of the diversification around it – the non-trend strategies – is an effort to make the medicine more palatable because that utility, that convexity that Cliff Asness is highlighting, can be hard to hold.”
That is not necessarily a bad thing, as long as the allocator knows that they are getting a diversified offering and that the program does not have some inherent bond or equity beta, which is not being divulged.
More Choices, More Decisions
Arguably a second shortcoming of the Asness argument is that while the SG Trend index includes the largest program of each of the managers, many CTAs have evolved to offer multiple programs to investors including pure trend, diversified trend or a multi-strategy. Large quant managers increasingly see themselves as solutions providers blending different strategies in different ways.
As Kevin Cole CEO and CIO of Campbell explained:
“Across our programs we want to deliver strong absolute return, low correlation or diversification to traditional assets and a stable level of risk. Now depending on the particular program and the way it is packaged that weight we put on each of these can vary. In our flagship program….we are laser focused on delivering the strongest risk-adjusted return, the highest Sharpe over the long term, a stable level of risk of about 10 vol, low correlation to stocks and bonds, and meaningful alpha above and beyond alt risk premia factors.…We also offer standalone trend strategies that are primarily for institutional investors looking for that more trend specific profile. Strong returns are an important part of that but also, we would have a greater emphasis on delivering that complementarity to traditional assets and that could be what you call Crisis Alpha or risk mitigation.”
Indeed, if an investor places a high value on Crisis Alpha even at the detriment of long-term returns, CTAs can offer programs that limit the equity exposure, or cap the equity beta in an effort to avoid significant drawdowns at times of reversal during an equity rally.
One such manager is Graham Capital. Ed Tricker CIO of Quant Strategies at Graham commented:
“Reducing equity exposure is interesting because … if markets have gone up a lot and then all of a sudden, they go down a lot, it takes a while to turn around. By not having that long exposure, you turn around more quickly. It’s sort of analogous to speeding up the system. The problem is you do incur an opportunity cost along the way. Now, historically, that opportunity cost has been about equivalent to the diversification benefit that you get, so it’s really been a wash. One could argue that fixed income is no longer the reliable friend it once was. I think, probably, that calculus has improved somewhat. There’s probably a little more utility to a capped beta version of Trend Following, for example, that looks a little bit more like fixed income used to.”
From that perspective the trade-off between return and Crisis Alpha is one that is increasingly acknowledged by managers, but it is a tradeoff which is being left to the investor to decide on depending on their own utility function and portfolio requirements.
Speed and Sizing
While the Asness paper focused on the strategy mix, and specifically the use of carry, as the possible culprit for returns showing less Crisis Alpha, one of the themes that emerged from our discussions was that the pursuit of Crisis Alpha can impact a number of choices CTAs make when designing Managed Futures programs. For example, the desire to deliver Crisis Alpha can be a consideration in the aggregate speed of the trend system and the desirability of having at least some allocation to faster trend systems. But that may come at a cost in terms of overall performance.
Marty Bergin, President at DUNN Capital Management explained:
“What we’ve found over the years in research is shorter timeframes or shorter lookback periods can mitigate drawdowns. But we also know that from a performance standpoint, the performance is not as good. But it’s become aware to us that institutional clients aren’t necessarily looking for the knock-the-ball out-of-the-park kind of performance. They’re more concerned about that drawdown.”
Another variable which may impact the extent to which a program can deliver Crisis Alpha is volatility sizing, a topic which often elicits emotional debate amongst trend followers. The “old school” way of running a Trend Following was to size positions at entry based on volatility, but to keep that position until exit without adjusting the position size as market volatility changes. The benefit of this approach, from the perspective of delivering Crisis Alpha, is that the program can benefit significantly from positions in markets which are trending and where volatility is expanding rapidly. Philosophically, the idea is that the program should have higher risk where markets are really starting to move. However, in our conversations with the largest CTAs there was an almost universal preference for dynamically adjusting position size for changes in market volatility.
As Svante Bergström Co-Founder and CEO at Lynx put it:
“I think it’s old-school. I think if you look at a year like last year, for example, or 2008, the less sophisticated you are, the better actually. When you keep big positions, you don’t care about volatility increasing. You just ride the trend and make a lot of money. But it’s in market environments where you struggle that you need to adjust to make sure that you don’t take too much risk and use that in a risk management context.”
Indeed, the strong performance of the SG Trend index last year, is arguably proof that the more modern approach to position sizing is still very effective in delivering Crisis Alpha.
The introduction of the term “Crisis Alpha” into the investment lexicon was a helpful addition but over time may have been misconstrued. Yes, Managed Futures strategies and Trend Following have at times delivered Crisis Alpha, largely because the strategies are opportunistic, unbiased and liquid.
But that is not a promise that these strategies will always deliver positive returns in crisis periods, but instead it’s the fact that Managed Futures have these characteristics that increase the likelihood of delivering Crisis Alpha, while at the same time generating returns in other time periods.
Many investors have historically relied on long bonds or long Volatility for their Crisis Alpha, but we saw in 2022 that these strategies can be unreliable in delivering Crisis Alpha. Given that neither of them have all three characteristics (opportunistic, unbiased and liquid) they should not be solely relied on by investors for their risk mitigation.
Perhaps, when all is said and done, particularly during the major crises and equity drawdowns, Trend Following and Managed Futures stacks up very favorably versus the alternatives in delivering “Crisis Alpha” after all.
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