European versus American trend-followers

 

A recent paper, "The Science and Practice of Trend-following System", makes the interesting observation that there is a difference between European and American CTAs or trend-followers. The paper tries to provide a unified system for trend-following, a noble cause. However, what piqued my interest was the authors' comment that there were three major trend-following classifications: European, American, and time series momentum. 

I have always believed and commented that there is a difference between the major European and American trend-followers. I have stated that Americans are ideologues who adhere to a system developed in the 70's and 80's, while Europeans are pragmatists who focus on any technique that seems to generate profits. Sepp and Lucic hold the view that European CTA focuses on continually adjusting positions based on current risk, coupled with exponential moving average systems. American trend-followers emerge from the technical system world, focusing on breakout systems that involve full positions based on the signal. The third system focuses on time series momentum systems, which are correlated with moving average crossover systems. 

You might think that these approaches are all the same, but you would be wrong.  The American system has the highest Sharpe ratio, but the other methods are not far behind. In a given year, there will be differences, but it is hard to say that one approach is superior to another. You are left with the issue of finding a strategy that works for your risk tolerance, and in this case, risk tolerance is based on your comfort with the return generation process. 

The hedge fund industry - Changed with Bernie Madoff

In our last post, we focused on the upheaval to the hedge fund industry from the GFC. The downside risk caused surviving hedge funds to innovate through forming management structures that attempt to gain scale and scope. Size and diversification as a form of hedging downside risk.

In this post, we focus on the second major upheaval to the hedge fund industry - the Bernie Madoff scandal. While hedge funds realized that they needed to gain scale and scope to save their businesses. Investors demanded more professional management and a broader scope of functions, as seen in other industries, in response to the uncertainty within the hedge funds in which they invested. Call it the rise of super due diligence. Of course, the government increased regulation, but investor due diligence also rose in response to fraud. The costs, especially for running a small hedge fund, increased because investors were not going to pare back due diligence because the manager was smaller. In fact, the risk of failure or fraud was likely higher for smaller funds. 

The Madoff change led to stronger internal controls, legal, and compliance departments. There was also a greater demand for transparency and contact with the manager, which increased the need for investor relations and marketing. The demand for risk management and exposure reporting led to the creation of separate departments from the investment business. 

Once the demand for transparency and more formal due diligence took hold, hedge funds had to provide many of the same investor services as long-only managers. The market shifted assets to larger firms, which in turn led hedge funds to focus on scale and scope, adopting more formal organizational structures.

The hedge fund industry - Changes from the GFC

The hedge fund industry - Changes from the GFC

 

The hedge fund industry has undergone significant changes since the Great Financial Crisis (GFC), which have not received sufficient attention. The focus is usually on performance, yet it is essential to consider hedge funds as a financial industry, one that evolves and adapts to the market environment. 

Hedge funds have not really developed new ways of generating alpha. They have adopted a greater use of quantitative tools, which represents a significant innovation in enhancing existing methods for generating alpha. However, the real innovation has been the movement toward vertical integration, a widening of scope through product development, and the formalization of management structure. 

The hedge fund industry was not immune to the significant declines in returns from the financial crisis. Many firms went out of business, and many experienced severe declines in cash flows. Assets under management declined, and the expected incentive fees were reduced or eliminated. The industry had to change because the surviving focused star manager could not survive another downturn like the GFC. 

The choices were clear, no different from those in other industries that underwent upheaval. First, the innovation of the hedge fund industry was to diversify the firm's offerings. This could be the same fund but with a broader market focus. It could also be different products within the same asset class or across asset classes, or it could be some customized product with features set for a large client. Second, there was a need to gain scale and better control costs through better professional management. This could take the form of formal marketing. It could also be a separate legal and compliance department, as well as separate risk management and trading departments. 

The desire for scale and cost control meant that the small shop, with its focused manager or personality, needed to become a departmentalized, professionally managed organization. There was an end to personality and a shift to departments that focused on specific tasks, overseen by the manager/owner.

This process was observed in many other industries in the US prior to the turn of the twentieth century. This is the story of American business and its pursuit of scale and scope. The hedge fund industry is not special. It follows the pattern of other industries.