9th February 2023
Summary
Trend following and managed futures strategies had one of their best years in 2022.
It is not the first time the strategies performed well when equities struggled.
However, despite solid long-term returns with low correlations to equities, many investors have been slow to embrace trend-following strategies.
The somewhat random return profile and periodic drawdowns can make it a tough investment to hold.
For investors able to overcome these challenges, trend following offers potentially valuable portfolio diversification, particularly amid heightened macro volatility.
Uncorrelated Returns
Trend following and managed futures funds were some of the strongest performers in 2022. The SG CTA index, an index of the 20 largest managed futures managers, was up 20% while the SG Trend index, comprising the largest funds focused on trend following, was up 27%.
It is not the first time these strategies have generated returns when equities were down: 2002 and 2008 were other strong years. However, the value of allocating to managed futures was even greater in 2022 given both bonds and equities declined on the year.
A longer-term perspective also reveals compelling reasons to include managed futures and trend following in a multi-asset portfolio. Since inception in 2000, the SG Trend and lower-volatility SG CTA Indices have posted annualised returns of 6.1% and 4.8%, respectively, both with slightly negative correlation to the S&P 500 Index.
Over that period, had an investor taken 20% from the 60-40 portfolio and allocated to a portfolio of trend-following funds, as measured by the SG Trend Index, the resulting portfolio would have had a higher return, lower volatility, smaller largest drawdown and higher Sharpe ratio than the 60-40 portfolio (Table 1).
Table 1: Including Trend Following Can Boost Returns and Reduce Drawdowns*
*Performance of the S&P TR Index, US 60-40 Portfolio, SG Trend Index and a Diversified Portfolio (80% 60-40 Portfolio, 20% SG Trend Index) Jan 2000 – Dec 2002.
Source: Bloomberg, Soc Gen, Archive Capital
Yet only a fraction of the investing community have embraced trend following and managed futures, and scepticism often surrounds the durability of the returns.
The Managed Futures Industry
One confusing element for investors may be the labels around the industry. Managers are sometimes called CTAs (commodity trading advisors), sometimes quant funds, sometimes managed futures and sometimes trend followers.
The term managed futures covers several categories like trend following, short-term trading, volatility trading, currency trading and commodity trading. The common denominator is a focus on trading futures (rather than cash instruments).
Managers in the industry typically use systematic approaches, testing their strategies on historical data and executing using computer algorithms. Trading is bi-directional, and diversified managers typically trade futures on government bonds, equity indices, currencies and commodities. According to data from Barclay Hedge, assets under management in managed futures amounts to over $400bn; the largest sub-category is trend following.
Profiting From Trends
The idea of following momentum in markets and sticking with the trend is not new. In the 18th century, economist David Ricardo reportedly advocated cutting losses short and letting profits run.
The belief underpinning trend following is that markets exhibit trends over time because the economy evolves gradually, market participants react to news at differing speeds and investors are subject to behavioural bias (such as rising prices tending to fuel more optimism and vice versa).
In any given year some markets will trend, and others will not. The essence of trend following is that by applying rules-based strategies, gains in trending markets will outweigh losses in non-trending markets. For example, interest rate futures trended strongly last year, offering great opportunities for trend followers. On the other hand, gold traded up and down in a broad range and would have been more challenging. Strong years for trend following tend to be those in which many markets experience big moves.
The rules around defining a trend and entering a trade are simple. The three most common methods are:
The price change over a certain period (e.g. one, three or 12 months).
Comparing two moving averages of differing durations.
Identifying markets ‘breaking out’, e.g., making a new three-month high or low.
Much of the skill in running a trend following strategy is in deciding which markets to trade, what speed to trade at, how to allocate risk and how to manage that risk. While many managers use trend following, approaches vary greatly around timeframe, number of markets traded, and whether to diversify trend following with other strategies.
The Behavioural Challenges of Investing in Trend Following
Arguably the biggest challenge of trend following is not running the strategy but staying invested. A few features of the return profile can make it challenging for investors.
1. Randomness of Returns
While the historical data point to attractive returns and low correlation to traditional assets, the timing of the returns is somewhat random. Markets can experience choppy periods without strong trends. Trend following had two notably tough periods in the last decade (2011-2013 and 2016-2018) when markets generally exhibited fewer trends. However, 2019, 2020 and 2021 were all positive years, and 2022 was a particularly strong year as greater macro volatility fuelled strong trends in markets.
2. Low Correlation to Equities
One of trend following’s greatest strengths may also be a weakness. While the low correlation to equities is a strong selling point, it means trend following can underperform when equities perform well. This should be great for investors running diversified portfolios, but many struggle to hold strategies they think are underperforming in a prolonged bull market.
3. Frequency of Gains and Losses
Behavioural finance also provides an insight into why trend following may be less prevalent in investors’ portfolios. Because of loss aversion, investors feel the pain of negative returns more strongly than the pleasure of positive returns. Although the SG Trend and the S&P 500 indices have generated similar returns since 2000, the S&P 500 has had noticeably more positive months (64% versus 55%). Gains for trend following are less frequent and come in bursts.
Outlook
Although timing when markets will trend is hard, two factors point to a potentially favourable market environment for trend following in 2023.
First, the volatility of macroeconomic variables such as GDP and inflation is much higher this decade than last. If sustained, that could lead to more volatile financial and commodity markets. ECB Executive Board Member Isabel Schnabel has even suggested the next few years may become known as the Great Volatility in contrast to the Great Moderation of the pre-Global Financial Crisis era.
Second, higher, more divergent, and more greatly fluctuating interest rates are potential positives. As futures are traded on margin, managed futures funds hold a lot of cash and benefit directly from higher rates. Divergences in rates and greater amplitude of the rates cycle may create better trading opportunities in interest rate markets and potentially in other markets such as FX.
The Fundamental Case for Investing in Trend Following
While you can speculate on the macro outlook, the fundamental case for allocating to trend following and managed futures depends on how you think markets work.
Markets have always experienced boom and bust cycles. If you accept the global economy and financial markets are complex, adaptive systems with markets participants prone to making errors due to behavioural biases, it is easy to see why crises recur. Periods of stability encourage complacency and greater risk taking until a catalyst or tipping point is reached – the so-called Minsky moment.
Currently, you could think we are enjoying an immaculate disinflation that favours risk assets. But a range of risks from high levels of debt, de-globalization, the greening of the global economy and de-dollarization lie beyond the horizon. And they represent just a sample of the known unknowns.
The trend follower acknowledges that predicting which of these will drive markets is impossible. Instead of trying, they allocate to a trading strategy that can react systematically to whatever unfolds, capitalise on major market trends, and provide diversifying returns in a portfolio.
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