Friday, May 29, 2020

If you want convexity, hold the trend-following CTA

What is the value of trend-following? In one word, convexity. This is clearly shown with the recent paper from the folks at KeyQuant, see "Unfortunately my CTA was diversified".  The idea of trend-following creating convexity is not new and variations of the non-linear performance has been produced in a number of different formats for decades. KeyQuant takes a different approach and compares the convexity of a trend-following CTA index against a non-trend-following CTA index. 

KeyQuant is able to show the difference between CTA styles with respect to convexity. You cannot get more stark CTA comparison, nor can you get a clearer picture of the benefit of style differences within the liquid alternative futures trading space. 

The capture measure puts into numbers what is visualized above. The capture measure looks at a threshold level and finds the associated return of a CTA strategy. A multi-strategy CTA is good. An investor will receive gains at the downside threshold levels, but the trend-follower will be even better with producing strong positive non-linear gains. There are two CTA worlds - a stable multi-strategy CTA that may mimic existing payoffs for other investments, or a trend-following CTA that may have lower stand-alone returns but will generate more convexity. 

An analysis using the return to drawdown ratio or Ulcer Performance Index (UPI) will generate a similar story. There will be a better pay-off scaled by a drawdown through using the pure trend-follower.  

Picking a CTA is a matter of  convexity choice. If there are no divergent moves and market stability, there will be little value with holding a strategy that has positive convexity. This is not a matter of saying there will be crisis offset from a trend-follower. It is question of whether an investor wants convexity. An investor may not want to pay for convexity in a stable financial world. However, if an investor is not sure of the environment, then having a strategy that can generate downside convexity is useful.

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