Alternative Risk Premia (ARP) focus: Trend Following

By Hamlin Lovell, NordicInvestor

Trend-following, or the momentum style or factor, is one building block for many alternative risk premia strategies, which typically pursue between three and eight risk premium strategies. Trend is also available on a standalone basis, in UCITS funds, ETFs and managed accounts.

The case for trend following is based on both theoretical grounds, and empirical evidence stretching back over decades and centuries.

Theory

Academic foundations for trend following include mass psychology and herd behaviour. This can lead to irrational situations where markets can become very overvalued or undervalued for extended periods, and trend followers aim to profit from these boom and bust cycles of “bubbles” that burst. “Herding” and “anchoring” are now recognised terms in the discipline of behavioural finance, which has spawned Nobel prize winners, and identified other biases that could help to explain trend following profits.

Another argument relates to the speed at which information filters into the markets. In the academic world of the strong form efficient markets hypothesis, all information should be instantly incorporated into market prices. In the real world, the data gets digested and acted upon at different speeds of minutes, hours, days, weeks and even months, by different investor groups. This helps to generate strong trends.

Most trend-following strategies use futures markets, which can provide additional returns from the term structure. Economist J.M.Keynes argued that relationships between hedgers and speculators in futures markets can create scope for speculators to profit from backwardation – when future prices are lower – or contango, when they are higher. If hedgers will pay a risk premium for certainty, this can be a source of profits for speculators. If hedgers are more broadly seen as non-profit making participants, they can include central banks, corporates and tourists in currency markets.

Evidence

AQR – probably the largest liquid alternatives manager in the US – has authored a paper called “A Century of Evidence on Trend-Following Investing”, going back to 1880. Its simulation (after full hedge fund fee of 2 and 20) generated returns of 11% – higher than on equities – but with volatility half that of equities. The Sharpe ratio of 0.76 was better than for equities.

Paris-based manager, Capital Fund Management (CFM), published research in March 2015, estimating the returns from a trend-following strategy going back to 1800. They concluded that there was statistically significant evidence of trend following generating a strong Sharpe ratio, averaging around 0.7- pretty close to the figure arrived at in the AQR study.

The book, “Trend Following with Managed Futures”, by Alex Greyserman of London-based CTA ISAM (which was founded by Man Group co-founder, Stanley Fink) and Kathryn Kaminski, now at Cambridge, Massachusetts, based CTA, AlphaSimplex, goes back even further, by using some 800 years of financial data. Again, the conclusions are that the reward for following trends is a persistent one.

Low correlation

The returns from trend following have continued through bull markets and bear markets for all asset classes; through economic booms, recessions and depressions; through inflation, hyper-inflation, deflation and stable prices; and through war and peace. For multi-year periods, trend following can be positively or negatively correlated to any asset classes, but over multi-decade periods that include a full cycle for all asset classes, the average correlation is very close to zero.

Crisis alpha

Moreover, the strongest returns from trend following have often, historically, occurred during crises and bear markets, which have thrown up some of the strongest trends. These have been seen most obviously in equity markets, but also in bonds, currencies and commodities, which have sometimes generated the greatest profits during such market phases. The resurgence of inflation made the late 1960s and 1970s a rough time for long only investors in fixed income and equities, but produced some of the best returns for CTAs that latched onto the stellar performance of commodities and currencies.

Funds

Low fee and flat fee trend following programmes are not necessarily branded or marketed as ARP, but as their fees are pitched at comparable levels, they may be competing for the same types of allocations from fee-sensitive investors.

Managers offering relatively low fee or flat fee trend-following strategies include AQR, Aspect Capital, Alpha Simplex, Crabel, Credit Suisse, Fulcrum, GAM Systematic/Cantab, GSA, Man Group, PIMCO and Winton (this list is not exhaustive, and given the number of new ARP products coming on stream, readers should watch out for new launches).

Most of these managers also offer trend-following products charging higher fees, which will often trade a wider range of markets than their low fee products, and may use some non-trend models.

Their flagship products vary substantially in terms of the percentage allocation to momentum, as they have diversified into other strategies, which can include counter-trend, pattern recognition, carry and equity market neutral. Some managers maintain an allocation of 80% or more to momentum, while others, such as Winton have cut it below 50% – and Winton recently told Risk.net that they intended to cut their trend allocation below 25% on their flagship strategy (while offering a pure trend strategy separately). Some CTAs and managed futures funds now contain more different strategies than some ARP funds.

Absolute return trend-following ETFs

Although managed futures funds can pursue a wide variety of strategies, in addition to, or instead of, trend following, trend-following ETFs are usually branded as “managed futures” strategies.

Traditional trend following CTAs go long and short of equities, bonds, currencies and commodities. One ETF pursuing this approach is the recently launched JP Morgan Managed Futures (ticker: JPMF).

A second ETF is First Trust Morningstar Managed Futures Strategy Fund (ticker:FMF).

A third ETF is the Wisdom Tree Managed Futures Strategy Fund (ticker:WTMF), which avoids equity index futures.

These ETFs tend to have an expense ratio just shy of 1%, which is close to many ARP products.

So far, very few ARP strategies seem to have been packaged into ETFs, possibly because most investors find a daily dealing UCITS or 40 Act fund offers adequate liquidity, and do not feel the need for real time, intraday trading. AQR has reportedly sought approval to launch active ETFs, though it does not appear to have done so yet.

Long only momentum ETFs

It is worth noting that the majority of momentum ETFs are in fact long only, and only trade single stock equities. They may specialise in US equities, large caps, small caps, non-US equities, emerging markets, particular sectors such as healthcare, technology, consumer staples, industrials, or materials, but ultimately they are mainly a play on the continuing equity bull market breaking new records and becoming the longest ever bull market.

2018-08-30T22:22:48+00:00By |Categories: ETFs & Indicies, Hedge Funds, The Nordic Brief|