Trend-following strategy as the new safe haven asset

 

Trend-following has often described as a "crisis alpha" strategy, but there has always been a simpler crisis alpha strategy over the last two decades, buying Treasury bonds. Given their strong negative correlation and positive total return during a market decline, Treasuries have all of the characteristics of a great crisis alpha strategy. That story may not hold going forward.

Treasuries have been viewed as the ultimate safe asset. Investors have the minimal credit risk from the US Treasury. Investors trade in the most liquidity market in the world, and if there was a crisis, fund flows would drive the price of the safe asset higher. Treasuries have been negatively correlated with equities; more negative than the correlation between equities and trend-following. The cost was low and in stable times you still received the coupon payments. What was not to like from using Treasuries as your hedge and crisis alpha?

Those halcyon days of Treasuries as a safe asset strategy are over. Liquidity can be a problem as seen in March. The Fed is now the largest holder of Treasury debt which changes the competitive nature of the market. Rates are low so you don't receive any yield especially inside 5-years to maturity, and the lower zero bound places a restriction on the potential for gain. You will not get a return kick to offset losses from an equity decline. Treasuries are not the safe asset as in years past. There is no total return offset to losses from risky assets.

So, what can an investor do to find an alternative safe asset? You can buy other forms of fixed income to offset the low yield, but safety becomes a question. Many other perceived safe assets have high risk characteristics so it is not clear they will provide safety when needed. 

Looking back in time, Treasuries have done a great job of providing portfolio safety and protection. Looking forward it is not clear that this will be repeated. On a forward looking basis, trend following may serve as a superior safe asset strategy. Instead of buying a zero return asset like bonds, investors should hold a strategy that will take positions based market price direction either up or down. Trend-following may still hold bond positions, but only if price direction warrants the exposure.

Buy the positive convexity strategy since the upside gain from holding bonds in a down market will not provide the upside needed to offset losses. Buy the diversified portfolio of trends because it offers a better mix of protection alternatives. It is a simple strategy. There are no guarantees it will do better in the short-run versus bonds, but in the current environment, it can still be the best alternative to a bond hedge.