What to expect as the risk-return trade-off for trend-followers

 

What is the expected return to risk trade-off for trend-following CTA's? Using a cross-section of trend-followers above $200 million in AUM that report to the Nilsson Hedge database, a regression analysis finds the return to risk trade-off is stable at approximately .6. Increasing from 10 to 20 percent volatility will raise expected return from 6 to 12 percent. Any investor who would like returns above 10% will have to lever a fund or find a manager with volatility between 15 and 20 percent. 

Of  course, there is variation away from the regression line, but a review of the 52 trend-followers in the sample tested show Sharpe ratios that range between just over 1 to a slight negative value. 

Using this information as a basis for comparison, a trend-following program that can consistently have a Sharpe ratio above one is exceptional. Clearly the rolling Sharpe ratio can move higher and lower than the range shown, but as the sample size increases, the average Sharpe is likely to fall within the range calculated. 

To get a higher Sharpe ratio a manager will have to blend other styles with trend-following to smooth the return and lower volatility. This is not an indictment of trend-following but the core strategy will have a long-term Sharpe ratio as a base. Improving on the base requires improvement in signal extraction, portfolio construction or risk management. Next to model improvement, adding other alternative risk premia is the most likely method for Sharpe improvement. All of these changes will have an impact on trend-following convexity which is the core reason for holding this strategy. These are the trade-offs that have to be considered by investors.