This article was first published in Pensions & Investments on 18 April 2020 here.
A strategy that can improve outcomes and reduce downside risk – if done right.
Institutional investors hit by the COVID-19 pandemic and resulting sell-off in global equity markets may be scratching their heads, wondering what they could have done differently. Traditional risk-hedging strategies, such as using options, buying low volatility/quality stocks and others, were either costly or not effective.
“Based on discussions I’ve had with institutional investors, a lot of them have tried to employ defensive strategies,” said Philip Seager, head of strategy – Quantitative Investment Solutions at CFM. “And those defensive strategies are generally based on complex option baskets. What we’ve generally found with options is that the premium to employ these strategies is very high. What that means is essentially you end up with a long-term negatively dragging P&L.”
What’s more, the premium goes up when markets go down.
“Think about when you’re buying insurance,” Seager said. “If you’re trying to insure your house or your car, you never buy insurance thinking that it’s going to be a long-term winning strategy, but it is a positively skewed strategy. So when you make a claim, it pays out. But the premium you pay is fairly high. The premium gets higher the more people want insurance and when the number of claims increases.”
One investment strategy not commonly considered as part of a risk mitigation arsenal but that can provide significant downside protection without the drag of a hefty premium during periods of drawdown is trend following.
“The remarkable thing about trend following is that you get that positive skew, albeit on long timescales, but you do not seemingly get the negative P&L drag,” he said. “Based on very long-term back tests, it seems to have a modestly positive Sharpe ratio.”
The underlying problem is that investors are humans and as such they have a penchant to follow trends, which makes them stray from ― and forget about ― diversification and the benefits it brings in both down and up markets. Also, they tend to be undisciplined or, in other words, performance chasers.
“If you’re undisciplined, and a performance chaser, then you tend to buy into an investment after an increase in performance,” Seager said. “Trend following is somewhat difficult for investors that inherently exhibit this behavioral bias to chase performance. People hold equities, they become complacent, and then it all ends in tears when there’s a crisis. People buy into trend following after the spike and are then disappointed by the subsequent often long periods of modest performance.”
Disciplined trend following can offer a Sharpe ratio in line with a buy-and-hold equity strategy but with uncorrelated drawdowns and some protection in extreme equity sell-offs. According to Seager, the skewed performance patterns of equities, with infrequent yet severe sell-offs, means investors often forget about the need for diversification. An allocation to trend following can diversify a portfolio.
For many investors, trend following can be difficult because, as Seager put it, “you get prolonged periods of not much happening. But then you get the occasional spike upward.”
Here’s how trend following can work. Consider the fact that a random walk of markets is by definition unpredictable – the long-term P&L of any strategy applied to it has to be flat. But it can fluctuate upward for several consecutive periods or downward for several consecutive periods, in a statistically insignificant manner. The trend follower can still come out ahead over short, statistically insignificant periods, hence the convexity or protection against big moves.
“Even a random price can sometimes drift strongly up or down and when that persists then the trend follower makes money — more and more if a crisis persists,” Seager said. CFM has investigated this statistical phenomenon in a mathematical research paper.1
“We’ve done a lot of work on trend convexity, which is a mechanical effect,” he said. “If one applies a trend-following approach to a random walk price time series then there is protection against big moves up and down.”
The coronavirus-driven market sell-off brings any strategy’s protective features into sharp focus. “At CFM, we’ve relied upon trend following historically as a performance driver, and we, and many others, have realized that improving risk-adjusted returns comes at the expense of reducing convexity. Based on discussions with clients, we have found, however, that there is a demand for convexity and protection. We therefore now have two products ― one trying to get the highest risk-adjusted returns and another strategy that is trying to get the most out of trend following in terms of convexity that then delivers slightly less in terms of Sharpe ratio,” Seager said.
Over the long term, investors using trend following as a return enhancer should expect a net Sharpe ratio of about 0.5. Research by CFM has found that gross returns from a six-month trend follower have never been negative in any historical 10-year period, unlike equities.2
In addition to equities, trend following has shown to deliver statistically significant excess returns in asset classes ranging from commodities to currencies to stock indexes to bonds, over very long-time series.
For equity investors, say a pension plan that is a long-term investor seeking to maximize risk-adjusted returns, rather than allocating 100% of the risk budget ― or, more narrowly, the equity budget ― to stocks, 20% could be allocated to trend following and the rest to equities.
“What you’re essentially doing is getting the same level of risk-adjusted returns with less volatility and, therefore, less draw down,” Seager explained. “That’s really what you’re achieving. And I think that is something most people would be very happy about.
“Throughout the cycle, the smart investor is diversified in risk-on and defensive strategies — a mix of equities with a diversifying and defensive allocation to trend following should give better outcomes,” he said. “It is never too late to adopt trend following.”
1“Making Fat Right Tales Fatter with Trend Following…most of the time.” CFM. November, 2018. https://www.cfm.fr/assets/Uploads/PDFs/2018-Making-fat-right-tails-fatter-with-trend-following-most-of-the-time.pdf
2 Y. Lempérière, C. Deremble, P. Seager, M. Potters, J. P. Bouchaud. “Two centuries of trend following,” Capital Fund Management, Paris, France. April 15, 2014. https://www.cfm.fr/assets/ResearchPapers/2014-Two-centuries-of-trend-following.pdf
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