London (HedgeNordic) – CTAs are enjoying a performance resurgence, and Swedish Lynx Asset Management is right in the midst of this surge. In 2021, equities and commodities made the best contributions; in the first three months of 2022, commodities have continued to be big contributors, while fixed income and interest rates – which lost money in 2021 partly due to reversals – have also become profitable markets as a clear uptrend in rates has developed due in part to building inflationary pressures.
Lynx allocates risk to models and markets based on return forecasts as well as volatility and covariance estimates. The year-to-date performance volatility of the Lynx Program has been benign despite risen market volatility. Some individual markets, such as Hong Kong and Chinese equities, or energy, have seen some violent counter-trend reversals, which might wrong-foot some trend models, but Lynx is well diversified and experienced at dealing with volatility surges. “It is actually easier to manage volatility spikes in an already volatile market environment, than it is to deal with a sudden shock such as the Covid crisis coming after an extended period of low volatility,” says Martin Källström, Partner and Senior Managing Director at Lynx.
“It is actually easier to manage volatility spikes in an already volatile market environment, than it is to deal with a sudden shock such as the Covid crisis coming after an extended period of low volatility.”
CTAs in general are raising assets, and Lynx has been growing its share of the inflows. Lynx saw its second largest ever annual net inflow of over USD 1.1 billion in 2021, and its assets have since reached an all-time high of over USD 7.5 billion. “Even though the large net inflow last year came mainly from our existing investors, we are now increasingly engaged with new investors interested in mitigating the risk in their portfolios and see the improved opportunity set for our strategy going forward,” says Källström.
Inflation and central bank policy divergence
Lynx’s thought leadership papers point out that most financial market shocks over the past 40 years have been deflationary, but the next one – which may have already started – could be inflationary. “Since the large asset price shifts seen in the summer of 2021, many sophisticated institutional investors have become increasingly concerned about how bonds and equities would perform should inflation rise. Finding investment strategies that could diversify traditional portfolios and perform in an inflationary period is challenging. Investors are increasingly looking at strategies like the Lynx Program to take on that role,” says Källström.
“Finding investment strategies that could diversify traditional portfolios and perform in an inflationary period is challenging. Investors are increasingly looking at strategies like the Lynx Program to take on that role.”
CTAs could well provide inflation protection. Lynx has analysed the Barclay CTA index back to its inception in 1980 and found that its returns were highest in those periods with the highest quartile of inflation, when equity returns were also lowest. Lynx does not use the 1970s to estimate how CTAs might perform in an inflationary climate, due to limited data on funds and the smaller number of tradable markets at that time. But it is clear that trend following CTAs are well positioned to latch onto uptrends in commodity prices as well as associated downtrends in other asset prices, such as fixed income in 2022. Lynx’s models increased their commodity exposure in 2021 and took advantage of strong performance in markets such as energy.
Policymakers’ responses to the new economic climate and inflationary pressures are also enhancing the opportunity set. “For instance, developed market central banks, which had been behaving in a synchronized way for many years, are now acting more independently, with some clearly committed to raising interest rates while others may not yet be ready to adjust their policies,” says Källström.
Green transition, supply chains and sanctions
Inflation is partly due to ESG oriented policies, including bans on “fracking” for gas in the UK and Netherlands, and reduced exploration activity from energy companies in response to institutional investor voting, that reduce the supply of some commodities. The green transition is also increasing demand for metals like copper and nickel that will power the electrification of vehicles and economies. Meanwhile, there were various supply chain bottlenecks, partly related to Covid, even before Russia’s invasion of Ukraine and the consequent sanctions, formal export and import bans, and informal “self-sanctioning,” exacerbated and complicated supply chain issues. All of this fans the flames of some commodity price trends, even if the data is not being directly analysed: “our non-price, fundamental data inputs do not attempt to explicitly model factors such as sanctions, since it would be too difficult and because their impact should be adequately reflected in market prices,” says Källström.
Model evolution and systematic macro
Lynx’s approach is constantly evolving in other ways. Machine learning techniques are used in both the 70% trend-following and 30% diversifying strategies buckets. In 2021, five new models were added and two were deleted, which is quite typical for any given year in the strategy’s evolution.
“The ex-IPM team are working with Lynx’s existing research team on systematic macro research based on fundamental economic hypotheses, and Lynx could now contemplate a systematic macro launch at some stage.”
In 2021 Lynx also hired four key employees from the former Stockholm based systematic macro manager, IPM – Informed Portfolio Management, which closed down operations last year. “The ex-IPM team are working with Lynx’s existing research team on systematic macro research based on fundamental economic hypotheses, and Lynx could now contemplate a systematic macro launch at some stage,” reveals Källström.
Protective returns
The Lynx Program has a very explicit objective to generate attractive returns while also diversifying and protecting portfolios in prolonged equity drawdowns. One of the key features contributing to the latter objective is that it retains exposure to shorter term models, which Lynx expects will provide more portfolio diversification benefits, even though their standalone Sharpe ratio might not be as high. “A faster and more reactive strategy gives us more chance to protect portfolios, whereas a longer-term strategy is more about risk premia. We do not want our style to drift away from providing diversification benefits,” argues Källström.
ESG, orderly financial markets and orderly transition
Lynx is not running ESG or impact strategies per se, but the firm has a distinctive approach to ESG, which considers its impact on financial markets, society and the planet. Realistically, Lynx’s ESG benefit is as an active participant in financial markets, providing liquidity and price discovery, helping hedgers, and reducing volatility, which also oils the wheels for other market participants. And Lynx sizes its positions to manage market impact.
These functions are also important for commodities such as natural gas as the world transitions from a brown to green economy. Natural gas has in 2021 and 2022 seen extraordinary volatility and made new all-time highs in Europe and Asia. Lynx argues if investors stop trading certain contracts, that could further increase volatility and interfere with price discovery, which would in turn impose costs on end users and make the transition process more difficult.
That said, Lynx is prepared to exclude some commodities, such as thermal coal and Malaysian palm oil, on ESG grounds, and others might be ruled out on liquidity grounds.
New ESG derivatives and engaging with exchanges
Lynx is generally open minded about trading new ESG versions of derivatives, providing they have sufficient liquidity. For instance, Lynx has recently started trading some ESG equity indices, to complement rather than replace traditional indices since the new contracts are not currently liquid enough to trade given their size. They are also considering carbon emission futures as liquidity has increased markedly in recent years. “We are committed to being an early participant in new ESG instruments but cannot be the first mover,” says Källström.
“We are committed to being an early participant in new ESG instruments but cannot be the first mover.”
But Lynx aspires to have a positive impact through encouraging ESG-oriented innovation in financial instruments. Since Lynx invests in derivatives rather than cash equities, it cannot vote proxies and instead of engaging with companies it is more worthwhile to engage with exchanges to spur them to introduce new ESG derivatives and improve contract specifications for established contracts to make them more sustainable. The deliverable criteria of a futures contract might for instance restrict the provenance of certain commodities or minerals to avoid sanctioned countries, war zones, polluted areas, or regions that are destroying rainforests. “We are getting very positive feedback from our engagement with exchanges and we believe this is a very concrete way for us to make impact,” says Källström.
This article features in HedgeNordic’s “Nordic Hedge Fund Industry Report.”
