By Graham Robertson, DPhil – Man AHL: Trend-following indices, such as the SG Trend and BTOP50, have posted their best year-to-end-August returns since 2000, against a backdrop of poor performance from traditional asset classes such as equities and bonds. This should not come as a surprise, in our view.  First, we are seeing the presence of strong trends in futures markets which are sensitive to macro-economic themes such as inflation. Second, trend-following has historically been observed to perform well during equity crises, and academic studies have also indicated an ability to perform well during fixed income crises too (see Bibliography for more details).

In this short article, we delve into some aspects of trend-following’s returns this year, specifically conventional futures and FX trend versus alternative markets trend, and question whether recent positive performance is just predicated on continued worries around inflation and weakness in traditional assets.

TREND-FOLLOWING: THE ALTERNATIVES STRATEGY DU JOUR

Trend-following strategies have had an outstanding 2022 so far, outperforming not only traditional asset classes like stocks and bonds, but also hedge funds in general (Figure 1).

We have written extensively about trend-following’s persuasive credentials during inflationary periods (Neville et al, 2021) and equity crises (Harvey et al, 2019, Hamill et al, 2017). The difference in performance between the BTOP50 and SG Trend indices, consisting of 20 and 10 constituents respectively, suggests there is considerable dispersion between trend-following managers in 2022. This could be down to various factors – risk targets, market allocations, models and trading speed, etc – which are hard to quantify without detailed knowledge of how managers trade. At Man AHL, however, we are fortunate to be running multiple trend-following programmes, spanning the full spectrum of markets, models and risk budgets, so we are potentially in a good position to isolate the real drivers of performance.

TRADITIONAL TRUMPS NON-TRADITIONAL IN 2022

What we have found in 2022 is that simple is best: pure trend strategies trading the largest futures markets have been the star performers. Macro-economic themes are driving markets in our view; inflation, central bank activity, war, supply chain disruption, de-globalisation and post-pandemic recovery, to name but a few. They are all interlinked, of course, but these are macro trends which are best observed in macro-sensitive instruments such as futures on global markets, be they country-level equity indices, government bonds or the largest of the world’s commodities. What are now called ‘non-traditional’ or ‘alternative market’ trend-followers generally boast a wider range of price drivers and better diversification through trading a broad range of typically over-the-counter (‘OTC’) markets such as emerging market interest-rate swaps or European hydro-electric power markets.

When trends are concentrated in certain markets at a given point in time, it stands to reason that the more concentrated the trend-follower is in these markets, the better performance is likely to be at that time. And this is the case at the moment; traditional trend-following (futures markets) has broadly outperformed non-traditional trend-following (mostly OTC markets).

In the long term, we believe diversification is the key feature in designing robust trend-following strategies. Figure 2 shows how an alternative markets trend-following strategy – with its greater diversification – outperforms a simulated futures/FX trend one. This is particularly true in the non-crisis periods. However, it is not the case for crisis periods such as the Global Financial Crisis of 2008 and the coronacrisis of 2020.

Can it be true that diversification is less effective in a crisis? ‘Crisis’ typically relates to developed markets, most often equities. News of a crisis in European hydro-electricity rarely makes the headlines or ripples through financial markets. In this case, we believe it stands to reason that global futures markets should be the instruments of choice for a trend-follower if an investor wishes a crisis hedge.

THE OUTLOOK FOR TREND

History is one thing, but to quote the first rule of Italian driving: “What’s-a behind me is not important.” What is ahead is what matters. Figure 3 reproduces a chart from Draaisma & Neville, 2022, showing that trend-following is not only a robust performer in inflationary periods in general, but also in the last six months of the episode, as well as in the 6- and 12-month timeframes following inflation’s peak.

This is important: it tells us that by using a trend-following strategy, we do not need to be able to predict when an inflationary period may peak or end. Intuitively, this is because given sufficient time, trend-following strategies are likely to adopt the market direction, whether it be long commodities, short bonds and equities in inflationary periods or the other way around after inflationary peaks.

CONCLUDING COMMENTS

At its heart, trend-following is an intuitive strategy; it should do well when markets move a lot, as they so often do in inflationary environments. Further, if an investor wants to tune a trend-following strategy to a crisis, and that crisis is in macro-economies, we believe instruments that are sensitive to the macro-economy should be used.

Bibliography

Neville, H., T. Draaisma, B. Funnell, C. Harvey, and O. Van Hemert, “The Best Strategies For Inflationary Times”, March 2021. Available at SSRN: https://papers.ssrn.com/sol3/papers.cfm?abstract_id=3813202

Harvey, C. R., E. Hoyle, S. Rattray, M. Sargaison, D. Taylor, and O. Van Hemert “The Best of Strategies for the Worst of Times: Can Portfolios Be Crisis Proofed?”. July 2019. Journal of Portfolio Management, Volume 45, number 5.  Available at https://www.man.com/maninstitute/best-of-strategies-for-the-worst-of-times

Hamill, C., S. Rattray, and O. Van Hemert, “Trend Following: Equity and Bond Crisis Alpha” (August 30, 2016). Available at SSRN: https://ssrn.com/abstract=2831926

Draaisma, T., and H. Neville (2022); “Inflation can go down as well as up”; https://www.man.com/maninstitute/road-ahead-inflation-up-down

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