Trend-following - If you want convexity, use a "pure" strategy

Managed futures have had a great performance run this year, but there has been significant dispersion in manager returns. A core problem is that managed futures is often confused with trend-following and all trend-following is not the same. All trend-followers are categorized as managed futures or CTAs as a regulatory matter, but all managed futures managers are not trend-followers. Managers may call themselves trend-followers but may have other strategies embedded in their funds which pollute their trend-following returns.

Cliff Asness of AQR has posted a recent research piece on trend-following to explain what it can and cannot do for investors. See "The Raison d'être of Managed Futures." Managers will often describe themselves as having a dual mandate of high average returns and strong returns during a market downturn, yet a pure trend-follower may have a hard time reaching this dual goal given the characteristics of trend-following. 

While not described as a divergent trading by Asness, trend-following is trading strategy that will make money when there are market dislocations or movements away from the status quo environment. If there is market stability, trend-following will not make money. Hence, returns may be high during concentrated periods that are often short-lived. There is less likely to be consistent returns because, by definition, diverges do not dominate markets. The strategy will do well over the long-run, but that does not mean that trend-following will make money all the time. There will be periods of underperformed offset by strong performance periods. The overall returns may be strong, but not during all sub-periods.

The AQR strategy is described as a pure trend strategy; consequently, it will do well when trends exist and have performance shortfalls during periods of stability. When compared to a supposed trend-following benchmark, the SG trend index, which is a bundle of many large managed futures managers described as trend-followers, the AQR strategy will have a different return pattern. 

The AQR research suggests that many trend-followers and the created index of managers, have mixed strategies that include more than just trend-following. To meet investor requests for both positive average return and downside protection, convexity, managers who often call themselves trend-followers but also include sometime like carry. 

We view carry as a convergent strategy that will do well when returns are stable, so managers may give-up some of the convexity in exchange for more stale returns through adding carry. The data suggests the SG trend has this mixed strategy. Additionally, there are portfolio structuring techniques that will impact trend-following. For example, volatility targeting, or volatility position sizing will have the impact of reducing risk exposure when there may be strong market dislocations. The trend exposure is cut at what may be the most opportune time for making money. The results are lower returns at market extremes.

Investors need to know what they are buying, and in the case of trend-following, you may not be getting a pure trend strategy because of mixed strategies and structuring. Is this false advertising? Perhaps, but a dampened trend may be what an investor wants. However, you should not be disappointed if in exchange for more stable returns you don't do as well during dislocations.