We have heard this story before, "Look at those market moves this year; of course, a trend-follower should make money." Some have made money in 2020. Some have not. Most have done better than the market. Still, many have underperformed relative to expectations given the circulating theme about "crisis alpha", or market divergences.
The key to understanding who will make money is to go back to basics. Are there trends? Did managers have a way of exploiting or identifying these trends? Did managers have high exposures to those markets that showed trends?
We have used the simple framework of Styles, Timing, and Markets (STM) to classify trend-followings. What is your style for finding signals? What is your timing or look-back period? What markets and exposures do you trade? However, this is all based on whether there are trends to exploit.
The folks at AQR have decomposed the drivers of trend in their research paper "You Can't Always Trend When You Want". Their research focuses on the simple idea that trend-followers make money when there are trends. If no trends, then no profits. Trend following performance can be broken into three parts, the average magnitude of the market move (absolute Sharpe ratio), the trend efficacy or beta that is exploited from the market move, and the diversification multiplier which measure the exposure to different markets.
For this year, there have been strong absolute market moves, albeit tempered when discounted by volatility. The big differentiator is the trend efficacy or ability of the manager to exploit the trends and market exposure differences. More diversified managers have seen a drag on performance, and those managers who cut exposures given the volatility spike lost trend efficacy at just the wrong time. The issue of whether CTAs are actually trend-followers is a topic for another time.
There were four major trends to exploit in 2020 but each needed different signal capturing. Bonds needed long-term trend exploiting. Equity needed intermediate trend tracking to get short at the end of February and then turn long at the end of March. Energy futures needed an intermediate model that could hold a trend in the face of volatility, and currency trading needed a shorter timeframe. No one trend approach would have been effective in all markets. Additionally, the concept of volatility-sized positioning worked against managers.
As in the recent past, the best potential financial trends were arrested through active government intervention. When governments subvert market divergences, trend following will not reach its potential. Cutting market tails may be in the public's interest, but it will distort the level of price dispersion. The large market moves of yesterday will not be seen in the central bank muted world of today.
We have used the simple framework of Styles, Timing, and Markets (STM) to classify trend-followings. What is your style for finding signals? What is your timing or look-back period? What markets and exposures do you trade? However, this is all based on whether there are trends to exploit.
The folks at AQR have decomposed the drivers of trend in their research paper "You Can't Always Trend When You Want". Their research focuses on the simple idea that trend-followers make money when there are trends. If no trends, then no profits. Trend following performance can be broken into three parts, the average magnitude of the market move (absolute Sharpe ratio), the trend efficacy or beta that is exploited from the market move, and the diversification multiplier which measure the exposure to different markets.
For this year, there have been strong absolute market moves, albeit tempered when discounted by volatility. The big differentiator is the trend efficacy or ability of the manager to exploit the trends and market exposure differences. More diversified managers have seen a drag on performance, and those managers who cut exposures given the volatility spike lost trend efficacy at just the wrong time. The issue of whether CTAs are actually trend-followers is a topic for another time.
There were four major trends to exploit in 2020 but each needed different signal capturing. Bonds needed long-term trend exploiting. Equity needed intermediate trend tracking to get short at the end of February and then turn long at the end of March. Energy futures needed an intermediate model that could hold a trend in the face of volatility, and currency trading needed a shorter timeframe. No one trend approach would have been effective in all markets. Additionally, the concept of volatility-sized positioning worked against managers.
As in the recent past, the best potential financial trends were arrested through active government intervention. When governments subvert market divergences, trend following will not reach its potential. Cutting market tails may be in the public's interest, but it will distort the level of price dispersion. The large market moves of yesterday will not be seen in the central bank muted world of today.
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