We introduce the simple arithmetic of portfolio construction where a strategy can be broken into a strategic allocation and a self-financing trading strategy.
For long/flat trend equity strategies, we introduce two potential decompositions.
The first implementation is similar to equity exposure with a put option overlay. The second is similar to a 50% equity / 50% cash allocation with a 50% overlay to a straddle.
By evaluating the return profile of the active trading strategy in both decompositions, we can gain a better understanding for how we expect the strategy to perform in different environments.
In both cases, we can see that trend equity can be thought of as a strategic allocation to equities – seeking to benefit from the equity risk premium – plus an alternative strategy that seeks to harvest benefits from the trend premium.
The Simple Arithmetic of Portfolio Construction
In our commentary A Trend Equity Primer, we introduced the concept of trend equity, a category of strategies that aim to harvest the long-term benefits of the equity risk premium while managing downside risk through the application of trend following. In this brief follow-up piece, we aim to provide further transparency into the behavior of trend equity strategies by decomposing this category of strategies into component pieces.
First, what do we mean by “decompose”?
As it turns out, the arithmetic of portfolios is fairly straight forward. Consider this simple scenario: we currently hold a portfolio consisting entirely of asset A and want to hold a portfolio that is 50% A and 50% of some asset B. What do we do?
Figure 1
No, this is not a trick question. The straightforward answer is that we sell 50% of our exposure in A and buy 50% of our exposure in B. As it turns out, however, this is entirely equivalent to holding our portfolio constant and simply going short 50% exposure in A and using the proceeds to purchase 50% notional portfolio exposure in B (see Figure 2). Operationally, of course, these are very different things. Thinking about the portfolio in this way, however, can be constructive to truly understanding the implications of the trade.
The difference in performance between our new portfolio and our old portfolio will be entirely captured by the performance of this long/short overlay. This tells us, for example, that the new portfolio will outperform the old portfolio when asset B outperforms asset A, since the long/short portfolio effectively captures the spread in performance between asset B and asset A.
Relative to our original portfolio, the long/short represents our active bets. A slightly more nuanced view of this arithmetic requires scaling our active bets such that each leg is equal to 100%, and then only implementing a portion of that overlay. It is important to note that the overlay is “dollar-neutral”: in other words, the dollars allocated to the short leg and the long leg add up to zero. This is also called “self-funding” because it is presumed that we would enter the short position and then use the cash generated to purchase our long exposure, allowing us to enter the trade without utilizing any capital.
In our prior example, a portfolio that is 50% long B and 50% short A is equivalent to 50% exposure to a portfolio that is 100% long B and 100% short A. The benefit of taking this extra step is that it allows us to decompose our trade into two pieces: the active bets we are making and the sizing of these bets.
Decomposing Trend Equity
Trend equity strategies are those strategies that seek to combine structural exposure to equities with the potential benefits of an active trend-following trading strategy. A simple example of such a strategy is a “long/flat” strategy that invests in large-cap U.S. equities when the measured trend in large-cap U.S. equities is positive and otherwise invests in short-term U.S. Treasuries (or any other defensive asset class).
An obvious question with a potentially non-obvious answer is, “how do we benchmark such a strategy?” This is where we believe decomposition can be informative. Our goal should be to decompose the portfolio into two pieces: the strategic benchmark allocation and a dollar-neutral long/short trading strategy that captures the manager’s active bets.
For long/flat trend equity strategies, we believe there are two obvious decompositions, which we outline in Figure 4.
Figure 4
Strategic Position
Trend Strategy
Decomposition
Positive Trend
Negative Trend
Strategic + Flat/Short Trend Strategy
100% Equity
No Position
-100% Equity 100% ST US Treasuries
Strategic + 50% Long/Short Trend Strategy
50% Equity 50% ST US Treasuries
100% Equity -100% ST US Treasuries
-100% Equity +100% ST US Treasuries
Equity + Flat/Short
The first decomposition achieves the long/flat strategy profile by assuming a strategic allocation that is allocated to U.S. equities. This is complemented by a trading strategy that goes short large-cap U.S. equities when the trend is negative, investing the available cash in short-term U.S. Treasuries, and does nothing otherwise.
The net effect is that when trends are positive, the strategy remains fully invested in large-cap U.S. equities. When trends are negative, the overlay nets out exposure to large-cap U.S. equities and leaves the portfolio exposed only to short-term U.S. Treasuries.
In Figures 5, we plot the return profile of a hypothetical flat/short large-cap U.S. equity strategy.
Figure 5: A Flat/Short U.S. Equity Strategy
Source: Newfound Research. Return data relies on hypothetical indices and is exclusive of all fees and expenses. Returns assume the reinvestment of all dividends. Flat/Short Equity shorts U.S. Large-Cap Equity when the prior month has a positive 12-1 month total return, investing available capital in 3-month U.S. Treasury Bills. The strategy assumes zero cost of shorting. The Flat/Short Equity strategy does not reflect any strategy offered or managed by Newfound Research and was constructed exclusively for the purposes of this commentary. It is not possible to invest in an index. Past performance does not guarantee future results.
The flat/short strategy has historically achieved a payoff structure that looks very much like a put option: positive returns during significantly negative return regimes, and (on average) slight losses otherwise. Of course, unlike a put option where the premium paid is known upfront, the flat/short trading strategy pays its premium in the form of “whipsaw” resulting from trend reversals. These head-fakes cause the strategy to “short low” and “cover high,” creating realized losses.
Our expectation for future returns, then, is a combination of the two underlying strategies:
100% Strategic Equity: We should expect to earn, over the long run, the equity risk premium at the risk of large losses due to economic shocks.
100% Flat/Short Equity: Empirical evidence suggests that we should expect a return profile similar to a put option, with negative returns in most environments and the potential for large, positive returns during periods where large-cap U.S. equities exhibit large losses. Historically, the premium for the trend-following “put option” has been significantly less than the premium for buying actual put options. As a result, hedging with trend-following has delivered higher risk-adjusted returns. Note, however, that trend-following is rarely helpful in protecting against sudden losses (e.g. October 1987) like an actual put option would be.
Taken together, our long-term return expectation should be the equity risk premium minus the whipsaw costs of the flat/short strategy. The drag in return, however, is payment for the expectation that significant left-tail events will be meaningfully offset. In many ways, this decomposition lends itself nicely to thinking of trend equity as a “defensive equity” allocation.
Figure 6: Combination of U.S. Large-Cap Equities and a Flat/Short Trend-Following Strategy
Source: Newfound Research. Return data relies on hypothetical indices and is exclusive of all fees and expenses. Returns assume the reinvestment of all dividends. Flat/Short Equity shorts U.S. Large-Cap Equity when the prior month has a negative 12-1 month total return, investing available capital in 3-month U.S. Treasury Bills. The strategy assumes zero cost of shorting. The Flat/Short Equity strategy does not reflect any strategy offered or managed by Newfound Research and was constructed exclusively for the purposes of this commentary. It is not possible to invest in an index. Past performance does not guarantee future results.
50% Equity/50% Cash + 50% Long/Short
The second decomposition achieves the long/flat strategy profile by assuming a strategic allocation that is 50% large-cap U.S. equities and 50% short-term U.S. Treasuries. The overlaid trend strategy now goes both long and short U.S. equities depending upon the underlying trend signal, going short and long large-cap U.S. Treasuries to keep the dollar-neutral profile of the overlay.
One difference in this approach is that to achieve the desired long/flat return profile, only 50% exposure to the long/short strategy is required. As before, the net effect is such that when trends are positive, the portfolio is invested entirely in large-cap U.S. equities (as the short-term U.S. Treasury positions cancel out), and when trends are negative, the portfolio is entirely invested in short-term U.S. Treasuries.
In Figures 7, we plot the return profile of a hypothetical long/short large-cap U.S. equity strategy.
Figure 7: A Long/Short Equity Trend-Following Strategy
Source: Newfound Research. Return data relies on hypothetical indices and is exclusive of all fees and expenses. Returns assume the reinvestment of all dividends. Long/Short Equity goes long U.S. Large-Cap Equity when the prior month has a positive 12-1 month total return, shorting an equivalent amount in 3-month U.S. Treasury Bills. When the prior month has a negative 12-1 month total return, the strategy goes short U.S. Large-Cap Equity, investing available capital in 3-month U.S. Treasury Bills. The strategy assumes zero cost of shorting. The Long/Short Equity strategy does not reflect any strategy offered or managed by Newfound Research and was constructed exclusively for the purposes of this commentary. It is not possible to invest in an index. Past performance does not guarantee future results.
We can see the traditional “smile” associated with long/short trend-following strategies. With options, this payoff profile is reminiscent of a straddle, a strategy that combines a position in a put and a call option to profit in both extremely positive and negative environments. The premium paid to buy these options causes the strategy to lose money in more normal environments. We see a similar result with the long/short trend-following approach.
As before, our expectation for future returns is a combination of the two underlying strategies:
50% Equity / 50% Cash: We should expect to earn, over the long run, about half the equity risk premium, but only expect to suffer about half the losses associated with equities.
50% Long/Short Equity: The “smile” payoff associated with trend following should increase exposure to equities in the positive tail and help offset losses in the negative tail, at the cost of whipsaw during periods of trend reversals.
Taken together, we should expect equity up-capture exceeding 50% in strongly trending years, a down-capture less than 50% in strongly negatively trending years, and a slight drag in more normal environments. We believe that this form of decomposition is most useful when investors are planning to fund their trend equity from both stocks and bonds, effectively using it as a risk pivot within their portfolio.
In Figure 8, we plot the return combined return profile of the two component pieces. Note that it is identical to Figure 6.
Figure 8
Source: Newfound Research. Return data relies on hypothetical indices and is exclusive of all fees and expenses. Returns assume the reinvestment of all dividends. Long/Short Equity goes long U.S. Large-Cap Equity when the prior month has a positive 12-1 month total return, shorting an equivalent amount in 3-month U.S. Treasury Bills. When the prior month has a negative 12-1 month total return, the strategy goes short U.S. Large-Cap Equity, investing available capital in 3-month U.S. Treasury Bills. The strategy assumes zero cost of shorting. The Long/Short Equity strategy does not reflect any strategy offered or managed by Newfound Research and was constructed exclusively for the purposes of this commentary. It is not possible to invest in an index. Past performance does not guarantee future results.
Conclusion
In this commentary, we continued our exploration of trend equity strategies. To gain a better sense of how we should expect trend equity strategies to perform, we introduce the basic arithmetic of portfolio construction that we later use to decompose trend equity into a strategic allocation plus a self-funded trading strategy.
In the first decomposition, we break trend equity into a strategic, passive allocation in large-cap U.S. equities plus a self-funding flat/short trading strategy. The flat/short strategy sits in cash when trends in large-cap U.S. equities are positive and goes short large-cap U.S. equities when trends are negative. In isolating the flat/short trading strategy, we see a return profile that is reminiscent of the payoff of a put option, exhibiting negative returns in positive market environments and large gains during negative market environments.
For investors planning on utilizing trend equity as a form of defensive equity, this decomposition is appropriate. It clearly demonstrates that we should expect returns that are less than passive equity during almost all market environments, with the exception being extreme negative tail events, where the trading strategy aims to hedge against significant losses. While we would expect to be able to measure manager skill by the amount of drag created to equities during positive markets (i.e. the “cost of the hedge”), we can see from the hypothetical example inn Figure 5 that there is considerable variation year-to-year, making short-term analysis difficult.
In our second decomposition, we break trend equity into a strategic portfolio that is 50% large-cap U.S. equity / 50% short-term U.S. Treasury plus a self-funding long/short trading strategy. If the flat/short trading strategy was similar to a put option, the long/short trading strategy is similar to a straddle, exhibiting profit in the wings of the return distribution and losses near the middle.
This particular decomposition is most relevant to investors who plan on funding their trend equity exposure from both stocks and bonds, allowing the position to serve as a risk pivot within their overall allocation. The strategic contribution provides partial exposure to the equity risk premium, but the trading strategy aims to add value in both tails, demonstrating that trend equity can potentially increase returns in both strongly positive and strongly negative environments.
In both cases, we can see that trend equity can be thought of as a strategic allocation to equities – seeking to benefit from the equity risk premium – plus an alternative strategy that seeks to harvest benefits from the trend premium.
In this sense, trend equity strategies help investors achieve capital efficiency. Allocations to the alternative return premia, in this case trend, does not require allocating away from the strategic, long-only portfolio. Rather, exposure to both the strategic holdings and the trend-following alternative strategy can be gained in the same package.
Decomposing Trend Equity
By Corey Hoffstein
On September 24, 2018
In Risk & Style Premia, Risk Management, Trend, Weekly Commentary
This post is available as a PDF download here.
Summary
The Simple Arithmetic of Portfolio Construction
In our commentary A Trend Equity Primer, we introduced the concept of trend equity, a category of strategies that aim to harvest the long-term benefits of the equity risk premium while managing downside risk through the application of trend following. In this brief follow-up piece, we aim to provide further transparency into the behavior of trend equity strategies by decomposing this category of strategies into component pieces.
First, what do we mean by “decompose”?
As it turns out, the arithmetic of portfolios is fairly straight forward. Consider this simple scenario: we currently hold a portfolio consisting entirely of asset A and want to hold a portfolio that is 50% A and 50% of some asset B. What do we do?
Figure 1
No, this is not a trick question. The straightforward answer is that we sell 50% of our exposure in A and buy 50% of our exposure in B. As it turns out, however, this is entirely equivalent to holding our portfolio constant and simply going short 50% exposure in A and using the proceeds to purchase 50% notional portfolio exposure in B (see Figure 2). Operationally, of course, these are very different things. Thinking about the portfolio in this way, however, can be constructive to truly understanding the implications of the trade.
The difference in performance between our new portfolio and our old portfolio will be entirely captured by the performance of this long/short overlay. This tells us, for example, that the new portfolio will outperform the old portfolio when asset B outperforms asset A, since the long/short portfolio effectively captures the spread in performance between asset B and asset A.
Figure 2: Portfolio Arithmetic – Long/Short Overlay
Relative to our original portfolio, the long/short represents our active bets. A slightly more nuanced view of this arithmetic requires scaling our active bets such that each leg is equal to 100%, and then only implementing a portion of that overlay. It is important to note that the overlay is “dollar-neutral”: in other words, the dollars allocated to the short leg and the long leg add up to zero. This is also called “self-funding” because it is presumed that we would enter the short position and then use the cash generated to purchase our long exposure, allowing us to enter the trade without utilizing any capital.
Figure 3: Portfolio Arithmetic – Scaled Long/Short Overlay
In our prior example, a portfolio that is 50% long B and 50% short A is equivalent to 50% exposure to a portfolio that is 100% long B and 100% short A. The benefit of taking this extra step is that it allows us to decompose our trade into two pieces: the active bets we are making and the sizing of these bets.
Decomposing Trend Equity
Trend equity strategies are those strategies that seek to combine structural exposure to equities with the potential benefits of an active trend-following trading strategy. A simple example of such a strategy is a “long/flat” strategy that invests in large-cap U.S. equities when the measured trend in large-cap U.S. equities is positive and otherwise invests in short-term U.S. Treasuries (or any other defensive asset class).
An obvious question with a potentially non-obvious answer is, “how do we benchmark such a strategy?” This is where we believe decomposition can be informative. Our goal should be to decompose the portfolio into two pieces: the strategic benchmark allocation and a dollar-neutral long/short trading strategy that captures the manager’s active bets.
For long/flat trend equity strategies, we believe there are two obvious decompositions, which we outline in Figure 4.
Figure 4
Strategic Position
Trend Strategy
Positive Trend
Negative Trend
Flat/Short Trend Strategy
100% Equity
-100% Equity
100% ST US Treasuries
50% Equity
50% ST US Treasuries
-100% ST US Treasuries
-100% Equity
+100% ST US Treasuries
Equity + Flat/Short
The first decomposition achieves the long/flat strategy profile by assuming a strategic allocation that is allocated to U.S. equities. This is complemented by a trading strategy that goes short large-cap U.S. equities when the trend is negative, investing the available cash in short-term U.S. Treasuries, and does nothing otherwise.
The net effect is that when trends are positive, the strategy remains fully invested in large-cap U.S. equities. When trends are negative, the overlay nets out exposure to large-cap U.S. equities and leaves the portfolio exposed only to short-term U.S. Treasuries.
In Figures 5, we plot the return profile of a hypothetical flat/short large-cap U.S. equity strategy.
Figure 5: A Flat/Short U.S. Equity Strategy
Source: Newfound Research. Return data relies on hypothetical indices and is exclusive of all fees and expenses. Returns assume the reinvestment of all dividends. Flat/Short Equity shorts U.S. Large-Cap Equity when the prior month has a positive 12-1 month total return, investing available capital in 3-month U.S. Treasury Bills. The strategy assumes zero cost of shorting. The Flat/Short Equity strategy does not reflect any strategy offered or managed by Newfound Research and was constructed exclusively for the purposes of this commentary. It is not possible to invest in an index. Past performance does not guarantee future results.
The flat/short strategy has historically achieved a payoff structure that looks very much like a put option: positive returns during significantly negative return regimes, and (on average) slight losses otherwise. Of course, unlike a put option where the premium paid is known upfront, the flat/short trading strategy pays its premium in the form of “whipsaw” resulting from trend reversals. These head-fakes cause the strategy to “short low” and “cover high,” creating realized losses.
Our expectation for future returns, then, is a combination of the two underlying strategies:
Taken together, our long-term return expectation should be the equity risk premium minus the whipsaw costs of the flat/short strategy. The drag in return, however, is payment for the expectation that significant left-tail events will be meaningfully offset. In many ways, this decomposition lends itself nicely to thinking of trend equity as a “defensive equity” allocation.
Figure 6: Combination of U.S. Large-Cap Equities and a Flat/Short Trend-Following Strategy
Source: Newfound Research. Return data relies on hypothetical indices and is exclusive of all fees and expenses. Returns assume the reinvestment of all dividends. Flat/Short Equity shorts U.S. Large-Cap Equity when the prior month has a negative 12-1 month total return, investing available capital in 3-month U.S. Treasury Bills. The strategy assumes zero cost of shorting. The Flat/Short Equity strategy does not reflect any strategy offered or managed by Newfound Research and was constructed exclusively for the purposes of this commentary. It is not possible to invest in an index. Past performance does not guarantee future results.
50% Equity/50% Cash + 50% Long/Short
The second decomposition achieves the long/flat strategy profile by assuming a strategic allocation that is 50% large-cap U.S. equities and 50% short-term U.S. Treasuries. The overlaid trend strategy now goes both long and short U.S. equities depending upon the underlying trend signal, going short and long large-cap U.S. Treasuries to keep the dollar-neutral profile of the overlay.
One difference in this approach is that to achieve the desired long/flat return profile, only 50% exposure to the long/short strategy is required. As before, the net effect is such that when trends are positive, the portfolio is invested entirely in large-cap U.S. equities (as the short-term U.S. Treasury positions cancel out), and when trends are negative, the portfolio is entirely invested in short-term U.S. Treasuries.
In Figures 7, we plot the return profile of a hypothetical long/short large-cap U.S. equity strategy.
Figure 7: A Long/Short Equity Trend-Following Strategy
Source: Newfound Research. Return data relies on hypothetical indices and is exclusive of all fees and expenses. Returns assume the reinvestment of all dividends. Long/Short Equity goes long U.S. Large-Cap Equity when the prior month has a positive 12-1 month total return, shorting an equivalent amount in 3-month U.S. Treasury Bills. When the prior month has a negative 12-1 month total return, the strategy goes short U.S. Large-Cap Equity, investing available capital in 3-month U.S. Treasury Bills. The strategy assumes zero cost of shorting. The Long/Short Equity strategy does not reflect any strategy offered or managed by Newfound Research and was constructed exclusively for the purposes of this commentary. It is not possible to invest in an index. Past performance does not guarantee future results.
We can see the traditional “smile” associated with long/short trend-following strategies. With options, this payoff profile is reminiscent of a straddle, a strategy that combines a position in a put and a call option to profit in both extremely positive and negative environments. The premium paid to buy these options causes the strategy to lose money in more normal environments. We see a similar result with the long/short trend-following approach.
As before, our expectation for future returns is a combination of the two underlying strategies:
Taken together, we should expect equity up-capture exceeding 50% in strongly trending years, a down-capture less than 50% in strongly negatively trending years, and a slight drag in more normal environments. We believe that this form of decomposition is most useful when investors are planning to fund their trend equity from both stocks and bonds, effectively using it as a risk pivot within their portfolio.
In Figure 8, we plot the return combined return profile of the two component pieces. Note that it is identical to Figure 6.
Figure 8
Source: Newfound Research. Return data relies on hypothetical indices and is exclusive of all fees and expenses. Returns assume the reinvestment of all dividends. Long/Short Equity goes long U.S. Large-Cap Equity when the prior month has a positive 12-1 month total return, shorting an equivalent amount in 3-month U.S. Treasury Bills. When the prior month has a negative 12-1 month total return, the strategy goes short U.S. Large-Cap Equity, investing available capital in 3-month U.S. Treasury Bills. The strategy assumes zero cost of shorting. The Long/Short Equity strategy does not reflect any strategy offered or managed by Newfound Research and was constructed exclusively for the purposes of this commentary. It is not possible to invest in an index. Past performance does not guarantee future results.
Conclusion
In this commentary, we continued our exploration of trend equity strategies. To gain a better sense of how we should expect trend equity strategies to perform, we introduce the basic arithmetic of portfolio construction that we later use to decompose trend equity into a strategic allocation plus a self-funded trading strategy.
In the first decomposition, we break trend equity into a strategic, passive allocation in large-cap U.S. equities plus a self-funding flat/short trading strategy. The flat/short strategy sits in cash when trends in large-cap U.S. equities are positive and goes short large-cap U.S. equities when trends are negative. In isolating the flat/short trading strategy, we see a return profile that is reminiscent of the payoff of a put option, exhibiting negative returns in positive market environments and large gains during negative market environments.
For investors planning on utilizing trend equity as a form of defensive equity, this decomposition is appropriate. It clearly demonstrates that we should expect returns that are less than passive equity during almost all market environments, with the exception being extreme negative tail events, where the trading strategy aims to hedge against significant losses. While we would expect to be able to measure manager skill by the amount of drag created to equities during positive markets (i.e. the “cost of the hedge”), we can see from the hypothetical example inn Figure 5 that there is considerable variation year-to-year, making short-term analysis difficult.
In our second decomposition, we break trend equity into a strategic portfolio that is 50% large-cap U.S. equity / 50% short-term U.S. Treasury plus a self-funding long/short trading strategy. If the flat/short trading strategy was similar to a put option, the long/short trading strategy is similar to a straddle, exhibiting profit in the wings of the return distribution and losses near the middle.
This particular decomposition is most relevant to investors who plan on funding their trend equity exposure from both stocks and bonds, allowing the position to serve as a risk pivot within their overall allocation. The strategic contribution provides partial exposure to the equity risk premium, but the trading strategy aims to add value in both tails, demonstrating that trend equity can potentially increase returns in both strongly positive and strongly negative environments.
In both cases, we can see that trend equity can be thought of as a strategic allocation to equities – seeking to benefit from the equity risk premium – plus an alternative strategy that seeks to harvest benefits from the trend premium.
In this sense, trend equity strategies help investors achieve capital efficiency. Allocations to the alternative return premia, in this case trend, does not require allocating away from the strategic, long-only portfolio. Rather, exposure to both the strategic holdings and the trend-following alternative strategy can be gained in the same package.