Tag: inflation

Summary

• Much like in 2008, managed futures as an investment strategy had an impressive year in 2022. With most traditional asset classes struggling to navigate the inflationary macroeconomic environment, managed futures has been drawing interest as a potential diversifier.
• Managed futures is a hedge fund category that uses futures contracts as their primary investment vehicle. Managed futures managers can engage in many different investment strategies, but trend following is the most common.
• Trend following as an investment strategy has a substantial amount of empirical evidence promoting its efficacy as an investment strategy. There also exist several behavioral arguments for why this anomaly exists, and why we might expect it to continue.
• As a diversifier, multi-asset trend following has provided diversification benefits when compared to both stocks and bonds. Additionally, trend following has posted positive returns in the four major drawdowns in equities since 2000.

Cut short your losses, and let your winners run. – David Ricardo, 1838

What is Managed Futures?

Managed futures is a hedge fund category originating in the 1980s, named for the ability to trade (both long and short) global equity, bond, commodity, and currency futures contracts. Today, these strategies have been made available to investors in both mutual fund and ETF wrappers. The predominate strategy of most managed futures managers is trend following, so much so, that the terms are often used synonymously.

While trend following is by far the largest and most pronounced strategy in the category, it is not the only strategy used in the space.¹ Managed futures can engage in trend following, momentum trading, mean reversion, carry-focused strategies, relative value trading, macro driven strategies, or any combination thereof. Any individual managed futures manager may have a certain bias towards one of the strategies, though, trend following is by far the most utilized strategy of the group².

Figure 1: The Taxonomy of Managed Futures

Adapted from Kaminski (2014). The most common characteristics are highlighted in orange.

What is Trend Following?

Simply put, trend following is a strategy that buys (‘goes long’) assets that have been rising in price and sells (‘goes short’) assets that have been decreasing in price, based on the premise that this trend will continue. The precise method of measuring trends varies widely, but each primarily relies on the difference between an asset’s price today and the price of the same asset previously. Some common methods of measuring trends include total return measurements, moving averages, and regression lines. These different approaches are all mathematically linked, and empirical evidence does not suggest that one method is necessarily better than another³.

Trend following has a rich history in financial markets, with centuries of evidence supporting the idea that markets tend to trend. The obvious question to then ask is: why? The past few decades of academic research has focused on explaining theories such as the Efficient Market Hypothesis and research into explanatory market factors (such as value and size), diminishing the amount of research being conducted on trend following.

Figure 2: The Life Cycle of a Trend

Adapted from AQR. For illustrative purposes only.

The classification of trend following as an anomaly, however, has not left it without theories for why it works. There are a number of generally accepted explanations for why trend following works, and more importantly, why the anomaly might continue to persist.

Anchoring Bias: When new data enters the marketplace, investors can overly rely on historical data, thereby underreacting to the new information. This can be seen in Figure 3 where, after the catalyst of new information enters the market, the price of a security will directionally follow the fair value of the asset, but not with a large enough magnitude to match the fair value precisely.

Disposition Effect: Investors have a tendency to take gains on their winning positions too early and hold onto their losing positions too long.

Herding: After a noticeable trend has been established, investors “bandwagon” into the trade, prolonging the directional trend, and potentially pushing the price past the asset’s fair value⁴.

Confirmation Bias: Investors tend to ignore information that is contrary to an their beliefs. A positive (or negative) signal will be ignored if the investor has a differing view, extending the time frame for the convergence of an asset’s price to its fair value.

Rational Inattention Bias: Investors cannot immediately digest all information due to a lack of information processing resources (or mental capacity). Consequently, prices move towards fair value more slowly as the information is processed by all investors.

As previously mentioned, methodologies may vary widely when analyzing an asset’s trend, but the general theme is to view an asset’s current price relative to some measure of its recent history. For example, one common example of this is to observe an asset’s current price versus its 200-day moving average: initiating a long position when the price is above its moving average or a short position when it is below. Extending Figure 2, we can graphically depict the trade cycle attempting to take advantage of such a trend.

Figure 3: The Life Cycle of a Trade

Source: Newfound Research, AQR. For illustrative purposes only

Of course, using such an idealized description of a trend is not typically what is found in the market, which leads to many false-starts, The risk-management decisions made to reduce the impact of these false-starts begins to highlight part of the attractiveness of the strategy as a diversifier.

Consider that the fair value of an asset is generally never known with a high degree of certainty. A trend following manager is thus reliant on the perceived direction of trend at any given time, and so, must make choices based on how the trend evolves or not.

Figure 4: Heads I Trend, Tails I Don’t

Adapted from Michael Covel. For illustrative purposes only.

When the model indicates that a trend has formed, the manager will initiate a position in the direction of the indicated trend (either short or long – blue line in Figure 4). As long as the trend continues, the strategy will hold that position, and only exit when the signal indicates that the trend no longer exists. At that time, the manager will remove the position, potentially taking the opposite position⁵.

The second case (red line in Figure 4) is one in which the trend reverses shortly after a position has been initiated. After establishing a position in the asset, the price of the asset reverts to its previous levels, possibly completely reversing in direction. In such a case, the signal will indicate that the trend no longer exists and recommend that the position be removed.

Historically, by quickly cutting losers and letting winning trades run, trend following has created a positively skewed return profile. Managed futures strategies tend to trade many different markets and underlying assets. This minimizes the impact of trends being rejected but may increase the probability of taking a position in an asset that has an outlier trend occurring that might be out of the scope of a traditional portfolio.

Kaminski (2014) refers to this characteristic as divergent risk taking⁶, where a divergent investor “profess[es] their own ignorance to the true structure of potential risks/benefits with some level of skepticism for what is knowable or is not dependable”.

This divergent risk behavior results in a positively skewed return distribution by not risking too much on a trade, removing the position if it goes against you, and allowing a trade to run if it is winning⁷.

The structural nature of trend following minimizes the size of any bets taken, and quickly eliminates a position if the bet is not paying off. By diversifying across many markets, asset classes, and economic goods, while maintaining sensible positions without directional bias, the strategy maintains staying power by not swinging for the fences and staying with a time-proven approach⁸, in a well-diversified manner.

Using Managed Futures as A Diversifier

The traditional investor portfolio has typically been dominated by two assets: stocks and bonds. In recent history, investors have even been able to use fixed income to buffer equity risk as high-quality bonds have exhibited flight-to-safety characteristics in times of extreme market turmoil. In the first two decades of the 2000s, this pairing has worked extremely well given that interest rates declined over the period, inflation remained low, and the bonds were resilient during the fallout of the tech bubble and the Great Financial Crisis.

In Figure 5, we chart the relationship between the year-over-year Consumer Price Index for All Urban Consumers (“CPIAUCSL”) versus the 12-month correlation between U.S. Stocks and 10-Year U.S. Treasuries⁹. We can see that negative correlation is most pronounced when inflation is low. Positive correlation regimes, on the other hand, have historically occurred in all realized ranges of CPI changes, the most striking occurring when inflation was extraordinarily high.

Figure 5: The Relationship Between Inflation and Equity-Bond Correlation

Source: FRED, Kenneth French Data Library, Tiingo. For illustrative purposes only.

Since trend following can hold both long and short positions, it has the potential to trade price trends in  assets in any direction that may emerge from increasing inflation risks.   This is highlighted by the performance of trend following in 2022, where the year-to-date real returns of U.S. equities¹⁰, 10-Year U.S. Treasuries, and the SG CTA Trend Index as of December 31, 2022 , were -19.5%, -16.5%, and +27.4%, respectively.  During 2022, trend following strategies were generally long the U.S. Dollar, short fixed income securities, and short equity indices. Additionally, the managers tended to hold mixed positions in the commodity space, taking long and short positions in the individual commodity contracts exhibiting both positive and negative trends.

Importantly, the dynamics exhibited throughout different economic regimes (such as monetary inflation vs supply/demand inflation) will unfold differently, so positions that were profitable in 2022 will likely not be the same in all environments. Trend following as a strategy, is dynamic in nature, and will adjust positioning as trends emerge and fade, regardless of the economic regime.

In addition to historically providing a ballast in inflationary regimes, one of managed futures’ claims to fame stems from the strategy’s ability to provide negative correlation in times of financial stress, specifically, in equity crises. The net result of including an allocation to trend following strategies during these periods has been a reduction in portfolio drawdowns and portfolio volatility.

Though managed futures have been in existence since the 1980’s, the strategy garnered its popularity coming out of the Great Financial Crisis, as it was one of the few investment strategies to provide a positive return. While this event shot the strategy to prominence, it was not an isolated incident. In fact, this relationship has been repeated frequently throughout history.

Table 1 shows the cumulative nominal returns of stocks, bonds, and managed futures when the equity market realized a greater-than 20% drawdown.

Table 1: Nominal Return of Equities, Bonds, and Managed Futures During Equity Crises

Source: FRED, Kenneth French Data Library, BarclayHedge. Calculations by Newfound Research. Time period is based on data availability. Performance is gross of all costs (including, but not limited to, advisor fees, manager fees, taxes, and transaction costs) unless explicitly stated otherwise Past performance is not a reliable indicator of future performance.

Since the inception of the SG CTA Trend Index¹¹, bonds have provided diversification benefits in three of the four large drawdowns. 2022, however, was the first period in which inflation has been a concern in the market, and U.S. Treasuries were insufficient to reduce risk in a traditional portfolio.

We can see, though, that the SG CTA Trend Index provided similar diversification benefits during the drawdowns in the first two decades of the century, but also proved capable while inflation shocks rose to prominence in 2022.

Figure 6: Performance From 1999 to 2022

Source: BarclayHedge, Tiingo. 60/40 Portfolio is the Vanguard Balance Index Fund (“VBINX”) and returns presented are net of the management fee of the fund. Time period is based on data availability. Performance is gross of all costs (including, but not limited to, advisor fees, manager fees, taxes, and transaction costs) unless explicitly stated otherwise. Past performance is not a reliable indicator of future performance.

Conclusion

Traditional portfolios consisting of equity and fixed income exposure have enjoyed two decades of strong performance due to favorable economic tailwinds. With the changing economic regime and uncertainty facing markets ahead, however, investors have begun searching for potential additions to their portfolios to protect against inflation and to provide diversifying exposure to other macroeconomic headwinds.

Trend following as a strategy has extensive empirical evidence supporting both its standalone performance, as well as the diversifying benefits in relation to traditional asset classes such as stocks and bonds. In addition, trend following is mechanically convex in that it can provide positive returns in both bull and bear markets.

Managed futures is a strong contender as an addition to a stock-and-bond heavy portfolio. Finding its roots in the 1980s, the strategy has a tenured history in the investment landscape with a demonstrated history of providing diversifying exposure in times of equity crisis.

In this paper, we have shown that trend following is a robust trading strategy with behavioral underpinnings, suggesting that the strategy has staying power in the long-run, as well as desirable characteristics due to the mechanical nature of the strategy.

As a potential addition to a traditional investment portfolio, managed futures provides a source of diversification beyond that of mainstream asset classes, as well as strong absolute returns on a standalone basis.

APPENDIX A: TREND FOLLOWING AS AN OPTIONS STRADDLE

A trend following strategy can benefit from both positive and negative price trends. If prices are increasing, then a long position can be initiated; if prices are decreasing, then a short position can be initiated. Said differently: a trend following strategy can potentially profit from both increases or decreases in price.

This characteristic is immediately reminiscent of a long position in an option straddle, where a put and call option are purchased with the same strike price. This option position would, thereby, benefit if the price moves largely either positive or negative¹².

Figure A1: Long Straddle Payoff Profile

Source: Newfound Research. For illustrative purposes only.

Empirically, these strategies have in fact performed remarkably similar. To illustrate this, we will create two simple strategies.

The first strategy is a simple trend following strategy that takes a long position in the S&P 500 when its prior 12-month return is positive, and a short position when its negative.

The second strategy will attempt to replicate the delta-position of a straddle expiring in one month, struck at the close price of the S&P 500 twelve months ago. We then compute the delta of this position using the Black-Scholes model¹³ and take a position in the S&P 500 equal to the computed delta. For example, if the price of the S&P 500 12-months ago was $3,000, we would calculate the delta of a straddle struck at $3,000. Since the delta of this position will range between -1 and 1, the strategy will use this as an allocation to the S&P 500.

Figure A2: Replicating Trend Following with Straddles

Source: Tiingo. Calculations by Newfound Research. Returns assume the reinvestment of all dividends. The S&P 500 is represented by the Vanguard 500 Index Fund Investor Shares (“VFINX”). For illustrative purposes only. Past performance is not a reliable indicator of future performance.

For both strategies, we will assume that any excess capital is held in cash, returning 0%. Figure A2 plots the growth of $1 invested in each strategy.

As we can see, the option strategy and the trend following strategy provide a roughly equivalent return profile. In fact, if we compare the quarterly returns of the two strategies to the S&P 500, an important pattern emerges. Both strategies exhibit convex relationships in relation to the S&P 500.

Figure A3: Trend Following Relationship to the Underlying

Source: Newfound Research. For illustrative purposes only.

Figure A4: Straddle Replication Relationship to the Underlying

Source: Newfound Research. For illustrative purposes only.

APPENDIX B: Index Definitions

U.S. Stocks: U.S. total equity market return data from Kenneth French Library. Performance is gross of all costs (including, but not limited to, advisor fees, manager fees, taxes, and transaction costs) unless explicitly stated otherwise. Performance assumes the reinvestment of all dividends.

10-Year U.S. Treasuries: The 10-Year U.S. Treasury index is a constant maturity index calculated by assuming that a 10-year bond is purchased at the beginning of every month and sold at the end of that month to purchase a new bond at par at the beginning of the next month. You cannot invest directly in an index, and unmanaged index returns do not reflect any fees, expenses, or sales charges. The referenced index is shown for general market comparison and is not meant to represent any Newfound index or strategy. Data for 10-Year U.S. Treasury yields come from the Federal Reserve of St. Louis economic database (“FRED”).

SG Trend Index:  The SG Trend Index is designed to track the largest 10 (by AUM) CTAs and be representative of the managed futures trend-following space.