Saturday, December 23, 2017

What we look for with trend-following beta - A simple set of rules

Trend-following as applied to managed futures has been around for decades, yet there is no universal agreement on what is or should be a trend-following benchmark that can serve as the strategy beta or as a trend-following strategy factor. A trend-following benchmark can be used to measure the factor beta of any manager. I can be defined as the core returns that an investor should expect from holding an investable portfolio in this strategy space. The benchmark returns should be expected performance from this strategy assuming there is no specialized manager skill.

Trend-following beta should not be a peer group of managers. A peer group may include specialized skill such as risk management, market selection, or filtering mechanisms and may be polluted by the use of a wider set of strategies than just trend-following. 

A peer universe can serve as a comparison but should not serve as the benchmark for any beta measure. There is nothing wrong with peer group comparisons, but it is not a well-defined strategy factor. It is a cluster of similar managers which may be highly correlated. This does not mean that peer group comparisons are not useful nor does it imply that managers should not try and beat a peer group. This means that any index like the SocGen CTA or BTOP50 index should serve not serve as a benchmark. A benchmark should be constructed through a set of rules that can be directly replicable and easily understood.

A trend-following benchmark index should rather represent a set of rules that can describe the investment strategy and can be employed to create a beta factor. We would like to outline what a trend-following benchmark should look like if it is to be used as the index for the strategy beta of any manager. I will note that momentum seems to have been more universally accepted and has a clearer definition through academic research. As an absolute return strategy that has not been created by academics, there is less clarity on trend-following rules definitions.

Keep it simple - A trend-following benchmark for measuring beta should be simple; easy to describe with how it is constructed and how and when it will generate returns. It should be investable and have characteristics that will be found to be useful to investors so they actually want to hold the benchmark index. A simple benchmark should not include filters that determine what trends to avoid. It is not "passive", but it has only a limited set of rules.

A limited set of markets - The gains from diversification are asymptotic. As the number of markets increase, the marginal gain from further diversification moves to zero; consequently, the number of markets that should be included in a benchmark should be adequate to provide the maximum diversification but limited so as to minimize transaction costs. 

The benchmark should be diversified - A good trend-following benchmark should include all major asset classes including equity indices, fixed income, rates, foreign exchange, metals, energy, and commodities. Nevertheless, there is a problem with determining the asset class allocation weights. 

Style consistent - If the benchmark is supposed to capture the returns from trend-following, then returns should only be generated from trend-following without any other investment styles or added features that are unrelated to trends. There should not be any filters that determine which trends to hold. There should not be a mixing of strategies between trend or momentum, nor should there be value indicators.

Timing range - The trend-following index should include a range of trend models since trends may have different time ranges. Nevertheless, trends employed should not be so short-term as to be distorted by liquidity or transactional cost effects.

Portfolio construction - The index should include all major asset class sectors and timeframes through an unbiased allocation procedure. Given the variety of markets and volume of trading, an allocation procedure that is based on volatility equalization is reasonable. Trading should be limited to the largest market so there will not be any distortions from size effects. Rebalancing should be well-defined.

Is there a single index that can serve as a trend-following benchmark? The jury is still out in terms of broad acceptance, but we believe there are some candidates. Nevertheless, there are more large managers who are offering low-cost stripped-down trend-following programs which they describe as a trend-following beta programs.  We think there is a place for these products for investors, yet there is also a place for alpha enhancers, albeit the burden is on these alpha enhancers to show that they can beat the benchmark index. 

If there is a defined benchmark, then managers can be compared based on their characteristics and not just peers. It is important, given the number of players in this space, to truly define and measure what is the actual trend-following beta or factor for a manager. Investors need to know whether a managed futures manager is a trend-follower or something else. 

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