There has been significant discussion concerning "crisis alpha" and trend-following managers. The concept of crisis alpha is valuable in its simplicity. Look for those periods with a substantial decline in equities, a crisis, and measure the return from trend-following program during these drawdowns. The excess return over the equity return decline will be the crisis alpha. The rationale for holding a trend manager is receiving the crisis alpha when core equity returns are falling.
Researchers, who have looked more closely at the crisis alpha story, have concluded that all crises are not the same, all trends are not the same, and all methods for exploiting trends are not the same. Crises can be a short life or last for extended time periods. The pandemic crisis of March 2020 was not the same as the GFC of 2008. Hence, one should not expect that the crisis alpha between these two events will be the same.
The fact that crisis alpha depends on the characteristics of crises and different portfolio features has led to confusion and distortion in the crisis alpha story. Trend-follower will not provide similar crisis alpha. Managers will define crises differently, and trend-following performance with varying crisis drawdowns and length lead to varying narratives for why perform was strong or weak. "Yes, my trend model has crisis alpha but not for this crisis; wait for the next one."
All assets and strategies may have a crisis alpha. It can be positive or negative based on its conditional behavior during these equity declines. For example, fixed income can have crisis alpha so trend managers should compare their performance against the simplest diversification option as well as other alternatives.
The crisis alpha benefit can come in several forms based on the style, timing, and markets that represent the trend-following program. There is crisis alpha gain from holding a diversified portfolio of markets. A low beta will allow for excess return versus a long-only equity position, but the key benefit comes from being able to adjust from long to short positions using a trend model.
Some crises, equity declines, can be quick with a drawdown in days while other can last months. Trend models may have short look-back periods or have a long-term trend identification. In general, a short or fast trend model will do better during short crises while longer crises will create better opportunities for longer-term models. The size of the crisis will impact potential crisis alpha. Deeper crises, a greater price decline, will allow the trend model to extract more return and will have more crisis alpha.
Managers may also have different weights on sectors. Hence, a trend manager that has a high equity risk exposure will have a different crisis alpha than a manager who has risk exposure more evenly distributed across equities, fixed income, currencies, and commodities.
Not often discussed is the issue of trend-following during the recovery phase after a crisis. The crisis alpha should be compared with the recovery alpha, the return between the max drawdown and recovery period. The key crisis alpha benefit is being able to have a smaller decline in wealth when funds may be needed for consumption during the crisis. The overall portfolio benefit is smoothing the growth path for wealth. The trend-following program with its high liquidity serves as a "piggy bank" for investors when a crisis makes it difficult to sell their declining and illiquid equity portfolio.
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