Friday, May 24, 2019

Trends are everywhere - Don't give-up on times series momentum

Discussions with investors suggest that there is frustration with trend-following returns, yet the evidence continues to grow that if there is one consistent style risk premia to buy, it is time series momentum. If you are a style betting man, this is the place to put your money if you follow the odds across time and asset classes. This is the conclusion if you follow the research conclusions from the research paper, "Trends Everywhere" which will be forthcoming in the Journal of Investment Management and written by the folks at AQR.

One of the tests for measuring the quality of an investment strategy is out of sample testing using a new dataset. The researchers in this working paper looked EM equity index futures, fixed income swaps, volatility futures, and long-short equity factors, a total of 82 new securities and 16 long-short equity factors that add to the 58 assets they have been analyzed in past research. Across traditional, alternative and long-short factors, the researchers find a gross Sharpe ratio of 1.60. 

The testing approach is as simple as you can get through looking at time series momentum over some past look-back period updated monthly. There are no frills or risk management and volatility is normalized. Within different asset groups, the returns are averaged. The calculated trend alpha relative to passive volatility scaled beta regressions are significant and economically meaningful. 

The alpha production is significant across all groupings except for credit indices. The value increases when diversified across a broad set of markets because there is little correlation across these markets. 

The gross Sharpe ratios are consistently positive although the Sharpe ratio for any one market may be vary greatly. Clearly, for any market or time period there will be performance variation, but a long-term investment in trend-following will be rewarded. 

Across all of these markets using time series momentum the benefits of positive convexity are measurable. The combination of being able to go long or short will allow downside protection without a change in strategy. 

There will be a difference in net performance once transactions costs and fees are added to this analysis. Execution costs will change with market conditions. These costs impact returns but not volatility so the Sharpe ratios will decline. However, the overall investment story will not be significantly different. Trend following returns will change with market conditions, but history and the data are on your side if you engage with this strategy.  

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