{"id":35492,"date":"2014-07-09T13:55:53","date_gmt":"2014-07-09T11:55:53","guid":{"rendered":"http:\/\/beta.next-finance.net\/strategie\/the-potential-of-trend-following-strategies-remains-intact\/"},"modified":"2019-12-30T23:00:07","modified_gmt":"2019-12-30T22:00:07","slug":"the-potential-of-trend-following-strategies-remains-intact","status":"publish","type":"post","link":"http:\/\/beta.next-finance.net\/en\/strategie\/the-potential-of-trend-following-strategies-remains-intact\/","title":{"rendered":"The potential of trend-following strategies remains intact"},"content":{"rendered":"

After two years of disappointing returns in 2011 and 2012,
\ntrend-following strategies \u2013 usually called trend followers
\nor more generically managed futures \u2013 which offer highly
\ndiversified exposure to the global financial markets,
\nexperienced mixed fortunes in 2013.<\/p>\n

The relatively poor 2013 performance of the Newedge Trend
\nIndex (2.67%), an index representing trend followers, could
\nreinforce the negative view that some investors have of these
\nstrategies: models unsuited to the market paradigm that
\nsurfaced with the crisis, broken performance drivers and
\noutdated strategies. There is quite a lot of criticism that trend
\nfollowers have had their hour of glory and now no longer
\nbelong in portfolio allocations.<\/p>\n

Yet, as is often the case, the reality is not so black and white.
\nAlthough the indices tracking trend followers struggled to
\ngenerate positive returns in 2013, the funds tracked by these
\nindices also posted more varied returns than usual. Some
\neven posted unprecedented gains, like the performance
\nof over 16% achieved by the Epsilon strategy managed by
\nthe Lyxor Asset Management teams. Therefore, in many
\nrespects, 2013 cannot be summed up as another year
\nmarking the decline of trend followers. On the contrary,
\nit heralds more of a revival for these strategies, which are
\namong the oldest in the hedge fund universe.<\/p>\n

A SYSTEMATIC INVESTMENT APPROACH
\nFOR UNRIVALLED DIVERSIFICATION<\/strong><\/p>\n

To better understand the cause of the difficulties encountered
\nby trend followers in recent years, a brief reminder of the
\nfounding principles of these strategies is required. Whereas
\ntraditional management relies on qualitative or quantitative
\nanalysis of asset prices, trend followers take positions in
\nmarkets solely based on the price trend, regardless of the
\nintrinsic value of assets.<\/p>\n

An age-old phenomenon in the markets, trends are the
\nproduct of inefficiencies originating in factors such as the
\ndifficulty some investors have in rebalancing their portfolios
\nor the herd instinct of the markets. They also lend themselves
\nwell to a systematic investment approach that allows them to
\nbe identified for the purpose of taking financial positions.<\/p>\n

By determining the statistical features of the behaviour
\nof each market (e.g. volatility, correlation, average return,
\nprobability of a jump in the price level, etc.) that are likely
\nto indicate a trend, the managers of trend followers can
\ndisregard the fundamental approach. Such a systematic
\napproach, which does not require an in-depth knowledge
\nof each market, enables them to expose the portfolio to
\na large number of markets at the same time. This results
\nin an investment strategy with an unparalleled degree of
\ndiversification capable of generating returns in both bearish
\nand bullish market conditions if trends are present.<\/p>\n

UNCORRELATED YET DISAPPOINTING PERFORMANCE IN 2011 AND 2012<\/strong><\/p>\n

What went wrong in 2011 and 2012, resulting in poor returns
\nfor investors? Before answering this question, it is important
\nto remember that trend followers experienced difficult years
\nin the past. In 2003 and 2004, at the end of a downward rate
\ncycle that had put pressure on the fixed income markets, an
\nenvironment characterised by weak trends and a sharp rise
\nin correlations among markets penalised model efficiency.
\nThe impact on performance was less severely felt, owing to
\nthe fact that money market rates \u2013 at which assets in a trend
\nfollower are remunerated[[It is worth bearing in mind that most of the assets in a trend follower are composed of cash, only a fraction of which \u2013 generally 10-15% of the total \u2013 is used to manage margins required by counterparties.]] \u2013 were significantly higher than
\nthey are today.<\/p>\n

1-PERFORMANCE OF TREND FOLLOWERS,
\nINTERNATIONAL EQUITIES AND BONDS
\n(JANUARY 2000 \u2013 JANUARY 2014)<\/strong><\/p>\n

A higher return than equities for a much lower drawdown<\/strong> <\/em>
\n\"a_higher_return_than_equities_for_a_much_lower_drawdown.jpg\"<\/p>\n

In 2011 and 2012, the market trend was basically a series
\nof risk-on\/risk-off movements that were very much dictated
\nby the string of plans aimed at stabilising the international
\nfinancial system. By causing periods of flight to quality
\n(sovereign debt, gold, silver) followed by periods of
\nrepositioning on risky assets (equities, emerging markets,
\ncommodities, currencies), political interventions invalidated
\na number of trends identified by the statistical models used
\nby trend followers. They also aligned all the markets which
\nfound themselves at the mercy of a single factor: political
\nintervention.<\/p>\n

At the same time, this simultaneous trend across all markets
\nconsiderably reduced the effectiveness of a traditional risk
\nallocation strategy. One of the basic principles of trend-following funds consists in taking positions in a large
\nnumber of markets by spreading the risk evenly across all
\nmarkets without appropriate consideration of the correlation.
\nHowever, this simplified approach towards diversification
\nseems to have reached its limits in 2011 and 2012.<\/p>\n

2-TREND AND CORRELATION INDICES<\/strong><\/p>\n

A normalisation of the markets reflected in the return of trends
\nand less correlation<\/strong> <\/em>
\n\"a_normalisation_of_the_markets_reflected_in_the_return_of_trends.jpg\"<\/p>\n

Although the criticism against trend followers is based on
\nthe reality of a non-trending market environment marked by
\nmajor interventionism on the part of monetary authorities, the
\nasset class has probably also suffered from the comparison
\nwith other strategies with lower volatility, including those
\nexploiting the bond recovery. However, trend followers
\nretain all of their appeal, the main one being their strong
\ndecorrelating virtue, which has been constant since 2001.<\/p>\n

3-ANNUAL CORRELATION OF TREND FOLLOWERS
\nWITH THE MAIN ASSET CLASSES, 2000-2013<\/strong><\/p>\n

On average, trend followers are characterised by a low level
\nof correlation with the main asset classes<\/strong> <\/em>
\n\"on_average_trend_followers_are_characterised_by_a_low_level.jpg\"<\/p>\n

MARKET NORMALISATION IN 2013<\/strong><\/p>\n

As illustrated in graph 2 on trend and correlation indices,
\nthe banking union agreement signed in the autumn of 2012
\nsparked a drop in correlation and breathed life into trend
\nfollowers. They performed well until 22 May 2013 when the
\nFederal Reserve announced the imminent tapering of the
\nbond buying programme. The direction taken by the debate
\non the US federal budget then plunged the markets back
\ninto a period of uncertainty, which immediately resulted
\nin another risk-on\/risk-off environment until a last-minute
\nagreement was signed in Congress in the autumn. This
\nextension of the transition to a new monetary policy regime
\nexplains the mixed returns of CTA funds in 2013, owing to the
\ndifficulty in capturing trends in an environment that remained
\nhazy.<\/p>\n

Initiated at the end of December, the reduced monetary
\nsupport to the US economy currently gives weight to the
\nassumption that the systemic crisis has been defused and
\nthat risk-on\/risk-off movements \u2013 detrimental to managed
\nfutures strategies \u2013 have been diluted.<\/p>\n

RISK ALLOCATION\u2019S TRUMP CARD<\/strong><\/p>\n

A closer look at the behaviour of trend-following strategies
\nin a context of exceptional levels of correlation between
\nthe markets where only a single factor comes into play, as
\nwas the case between 2008 and 2012, reveals areas for
\nimprovement. Unlike in 2008, when persistent upward gold
\nand commodity trends enabled models to shine, the lack
\nof trends brought this to an end in 2011-2012. This episode
\ncalls for a reflection on the identification of market regimes.<\/p>\n

The quality of the statistical models used to identify a market
\ntrend is the starting point for a trend follower. The high level of
\ncorrelation seen in 2011 and 2012 highlighted the importance
\nof the allocation model, whose ability to sufficiently diversify
\na portfolio is a prerequisite for the long-term success of a
\ntrend follower covering different market regimes.<\/p>\n

A standard managed-risk allocation based solely on the
\nknow-how and experience of investment teams is not
\nenough. Formalising the problems associated with risk
\nallocation provides a more documented view of a position\u2019s
\nimpact on the portfolio\u2019s overall risk.<\/p>\n

This is what has driven Lyxor\u2019s research teams since 2011.
\nHaving proved conclusive over the nine months during which
\nit was tested on a simulated basis, an alternative allocation
\nmodel was rolled out in September 2012. For Lyxor, which
\nis determined to stick to a trend-following strategy over the
\nmedium to long term where other trend-following funds allow
\nthemselves to vary their approach every so often, this new
\nallocation model strengthens the management process.<\/p>\n

A WELL-DESERVED PLACE IN ASSET ALLOCATION<\/strong><\/p>\n

A number of players in the collective, traditional and
\nalternative investment business already realised the
\nchallenges facing risk allocation a few years ago.<\/p>\n

For managers of trend-following funds, integrating these
\nissues is strategically important. The challenge consists in
\nbuilding the competitive advantages that this strategy has
\nover other asset classes in the long term.<\/p>\n

In fact, in the long term, managed futures already display
\na better risk\/return ratio than most of the other risky asset
\nclasses. They also stand out for their lack of correlation to
\nthe major market indices, which currently makes them one
\nof the most effective alternative investment instruments. <\/p>\n

For example, unlike long\/short funds, whose performance
\nincludes, depending on the strategy, an equity, credit or
\nbond component, trend followers do not have any structural
\nrelationship with a specific market. This decorrelation may
\nbe detrimental, particularly during market rallies when trend
\nfollowers will underperform. Yet it has its advantages. When
\nsharp downturns occur, as was the case in 2008, trend
\nfollowers fare well, unlike other alternative strategies.<\/p>\n

4-PERFORMANCE OF ALTERNATIVE STRATEGY
\nINDICES SINCE 2000<\/strong><\/p>\n

Relatively stable performance over the long term<\/strong> <\/em>
\n\"relatively_stable_performance_over_the_long_term.jpg\"<\/p>\n

The performance distribution of hedge funds is radically
\ndifferent from that of trend-following strategies which have
\na positive skew. When they fall, losses are much less severe
\nthan what the strategy\u2019s volatility would lead us to assume.
\nAnd although they often shed little, they post a sharp rise
\nwhen they make gains.<\/p>\n

The introduction of trend-following strategies in a traditional
\nportfolio reveals all the benefits of diversification. Thus, as
\nmight be expected from adding a decorrelated asset class
\nto a portfolio, the mean-variance analysis of the returns of a
\nportfolio composed of international equities and bonds, to
\nwhich an allocation to a trend-following strategy is added,
\ngenerates a more effective portfolio as it is more diversified.
\nThis positive observation justifies an unbiased examination
\nof what trend-following strategies have to offer when defining
\nthe investment strategy.<\/p>\n

5-EFFICIENT FRONTIER OF A PORTFOLIO
\nWITH THREE ASSETS<\/strong><\/p>\n

Trend-following funds improve the efficient frontier<\/strong> <\/em>
\n\"trend-following_funds_improve_the_efficient_frontier-1.jpg\"
\n\"trend-following_funds_improve_the_efficient_frontier-2.jpg\"