“The challenge with trend-following is consistency in the non-crisis periods and modeling innovation must be the answer to that.”
- Leda Braga, founder and CEO of Systematica from HedgeNordic June 2020.
Most investors who have studied trend-followers will agree with the long-held framework that the strategy is like a portfolio of look-back straddles. The straddle has positive convexity and will do well when there is a market divergence. If market prices go the wings of the straddle, the trend strategy will make money. This all makes sense, but there is a catch. If there are no trends or market moves, the investor is out of luck and will not likely receive a stand-alone return. No trends, no profits. Investors have to pay for the convexity and that is the cost.
Leda Braga describes this key challenge for her firm and for the trend-following CTA industry. Some managers have just responded that trend-following is non-predictive. You make money when trends occur, loss when they don't appear, and you learn to accept what the markets will give you. As a narrative, this often leaves investors with an empty feeling. It is true, but how can you truly get behind a manager that tells this story.
Managers have attempted to address this issue through adding other strategies that are negatively convex. A perfect addition is some form of carry that will do better in a stand-alone environment over a divergent strategy that makes money in the tails of the distribution. Unfortunately, if markets are stable for longer periods of time, some managers will continually increase their exposure to convergent strategies. At the same time, from Minsky we know that longer periods of stability sow the seeds for a greater divergence in the future. Low volatility leads to complacency and simultaneously increases the reach for risk and the desire to hold carry strategies that provide returns under stability.
Investors need question managers on how they address this challenge. The answer could be to de-emphasize trend-following but all that means is that manager will not give you what you may have initially wanted. The research challenge is whether there are new analytic tools or methods that can exploit limited price moves consistent with trend-following yet keep the straddle benefits.
Managers have attempted to address this issue through adding other strategies that are negatively convex. A perfect addition is some form of carry that will do better in a stand-alone environment over a divergent strategy that makes money in the tails of the distribution. Unfortunately, if markets are stable for longer periods of time, some managers will continually increase their exposure to convergent strategies. At the same time, from Minsky we know that longer periods of stability sow the seeds for a greater divergence in the future. Low volatility leads to complacency and simultaneously increases the reach for risk and the desire to hold carry strategies that provide returns under stability.
Investors need question managers on how they address this challenge. The answer could be to de-emphasize trend-following but all that means is that manager will not give you what you may have initially wanted. The research challenge is whether there are new analytic tools or methods that can exploit limited price moves consistent with trend-following yet keep the straddle benefits.
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