Trend-following as negative crisis beta as well as crisis alpha

 

Trend-following has been described as crisis alpha. This has been a useful depiction of the strategy, but it focuses on the idea of alpha creation when trend-following is also focused on dynamic beta. There is return unassociated with beta, the alpha of trading other markets than equities, and there is dynamic beta associated with returns based on market timing. There is alpha during crises, but when looked at all periods, the value of beta return is greater than the alpha return contribution.

There is diversification of assets classes, but trend-following, because it allows for long and short positions, is really about market-timing which creates long and short beta. It is this changing beta which is the true driver of returns and diversification. This focus on change beta is described in the Quantica Capital "Negative crisis beta and the hidden market timing ability of trend-following CTAs".

The focus of this paper is that the core value-added of trend-following can time markets. In particular, it has the ability to time equity markets which will mean that its beta will move between positive and negative values. Over the long run, this time will lead to a beta that is close to zero for equities. This will still lead to risk mitigation, but the form of this mitigation is through timing. This applies to all the markets traded, but Quantica focuses on the equity exposure. 

Quantica argues that 2/3rds of the the industry's total retune has been generated during the 16 worst calendar quarters for equity markets while the 81 remaining quarters are associated with the remaining third for the period from 2000 to 2024.

About 80% of the total trend-following performance can be attributed to equity beta either positive or negative and it made a positive contribution in 70 of 97 quarters. Negative crisis beta led to a positive contribution in 15 of 16 worst quarters which was about 40% of trend-following in those periods. Trend-followers have equity market timing ability. If you restrict long equity exposure will have a significant negative impact on performance, so don't restrict equity exposure for trend-following. Allow trend-followers to take their timing risk and you will see both return improvement and risk mitigation.

Nevertheless, crisis alpha still exists and is a significant contribution to returns during periods of negative equity returns. Trend-following is not just a crisis alpha story, and it is not a crisis beta story. It is a combination of timing with diversification.