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Pros and Cons of Replicating “All-Stars” Trend-Followers

Stockholm (HedgeNordic) – Andrew Beer and his team at Dynamic Beta investments (DBi), which is part of asset management network iM Global Partner, believe that trend-following managed futures are the most valuable diversifier for a portfolio of stocks and bonds. Since 2000, the SG CTA Index has demonstrated strong relative returns, low correlation to equities and bonds, and the ability to deliver positive returns during periods of market stress. Attracted by these return properties, Beer and Mathias Mamou-Mani have designed a strategy – available via both a U.S.-listed ETF and a Europe-domiciled UCITS structure – that replicates the performance of the world’s leading trend-following managers in a more cost-efficient and accessible manner, while also addressing the issue of single-manager risk.

“We’re not traditional managed futures guys, but we fell in love with the space back in 2015,” says Andrew Beer, reflecting on their search for a strategy to complement a long-only equity portfolio in a challenging market environment. “We looked at the managed futures space and we loved the diversification benefits on two dimensions,” he notes. First, its zero correlation with both stocks and bonds. Second, the presence of ‘crisis alpha,’ which implies that “the strategy tends to do best when you need it most.”

“We looked at the managed futures space and we loved the diversification benefits on two dimensions.”

Andrew Beer, Founder and a Managing Member of DBi

Trend-following managers demonstrated solid performance during significant market downturns such as the dotcom crash in the early 2000s and the global financial crisis of 2008. Particularly noteworthy was their resilience during the market downturn in 2022, when both equities and bonds suffered losses simultaneously. “2022 was not a just bad bear market for equities, but it was a terrible bear market for bonds and equities at the same time,” recalls Beer. “In turn, trend-followers had their best year ever,” potentially solidifying their role as portfolio diversifiers. Despite their proven value, Beer highlights several challenges investors encounter when attempting to access this market.

Single-Manager Risk, Drawbacks of Liquid Alts, and Cost Structure

“The first major issue when considering investing in this space is single-manager risk,” cautions Beer. This challenge, often described by allocators as ‘soul-destroying,’ stems from the variability in performance among trend-following managers. “You want to believe that AQR, Man Group, or Winton can do no wrong,” he notes, yet the constituents of the SG CTA Index exhibit significant dispersion in their performance. One approach for large asset allocators to address this challenge is to invest in two to three prominent trend-following managers to achieve diversification. However, this strategy is primarily feasible for larger allocators with the capital to invest in traditional fund structures. Simpler structures like mutual funds or UCITS may not offer the same advantages due to inherent constraints.

“The first major issue when considering investing in this space is single-manager risk. You want to believe that AQR, Man Group, or Winton can do no wrong…”

Andrew Beer, Founder and a Managing Member of DBi

The more liquid alternatives in a mutual fund or UCITS structure tend to underperform compared to the original structures, observes Beer. “If you are a wealth manager enthusiastic about the return stream and characteristics of the SG CTA Index, but you are restricted to investing through a mutual fund or UCITS fund, you won’t achieve the desired returns,” says Beer. To illustrate, the SG CTA index posted gains of approximately 26 percent before fees in 2022, whereas mutual fund versions in the US lagged by ten percentage points. “The constraints are a bit tougher in the UCITS land,” Beer explains.

“How can we achieve the pre-fee performance of the group, charge less, maintain the same return profile as the group, and perhaps even enhance alpha?”

Andrew Beer, Founder and a Managing Member of DBi

Lastly, and equally important, traditional trend-following managers have high fee structures, which, as Beer observes, “often seem secondary in good years.” However, their impact can be substantial for long-term allocators. In choppy markets, the asset class may generate annual pre-fee returns of 3-5 percent over cash, but these gains are eroded by fees and expenses, leaving returns no better than cash. “Despite the fees that hedge funds charge, trend-following managed futures remain a great asset class, even with those high fees,” argues Beer. Consequently, Beer and his co-partner Mathias Mamou-Mani posed the question, “How can we achieve the pre-fee performance of the group, charge less, maintain the same return profile as the group, and perhaps even enhance alpha?” The answer lies in replication.

Replication: Mirroring the “All-Stars”

In essence, managed futures funds seek out trends in futures contracts across four asset classes: rates, currencies, commodities, and equities. These funds analyze historical price data to predict whether certain instruments will keep going up or down. “You can think of them as “wave detectors:” they constantly monitor 50, 70 or more individual futures contracts across the market sea,” explains Beer. “The rationale is that greater diversification increases the likelihood of catching trends in cocoa or any other lucrative trend out there. Waves are unpredictable; they come, and no one wants to miss them.”

The replication strategy involves identifying the core positions of a representative basket of top trend-following managers and then investing in the most liquid futures contracts to achieve comparable exposure. “We are not building our own models to compete with these experts because they are all incredibly smart,” contends Andrew Beer. “Yet, when you look at the space statistically, none of them is consistently smarter than everybody else.” Therefore, DBi’s replication approach aims to mirror the positions of the 20 “all-stars” in the SG CTA index by analyzing approximately four weeks of average daily net returns.

Keep it Simple

After making an adjustment to reach the pre-fee returns of the SG CTA index, the team at DBi employs a quantitative technique known as quadratic optimization to extract the approximate positioning, both long and short, of those trend-followers across ten major futures contracts. “These ten contracts account for the majority, around 90 percent or more, of the pre-fee returns over time,” emphasizes Beer. “Our research process tends to be the most simple and straightforward to avoid fooling ourselves.”

“These ten contracts account for the majority, around 90 percent or more, of the pre-fee returns over time. Our research process tends to be the most simple and straightforward to avoid fooling ourselves.”

Andrew Beer, Founder and a Managing Member of DBi

“We essentially picked the ten futures contracts that we thought were the most significant, most important, and liquid,” says Beer. In currencies, DBi focuses on the USD-EUR pair, and on the S&P 500 in equities. In treasuries, they target two-year, ten-year, and 30-year treasuries, and in commodities, their focus lies on gold and oil. Although DBi may be avoiding 90 out of the 100 instruments that most other trend-followers are exposed to at any given time, the long-term significance of capturing trends in more esoteric futures markets is limited,” according to Beer.

Partial Limitations

The concentration on a select few futures contracts introduces a partial limitation of replication. “There is a limitation in that occasionally we won’t replicate as much of their returns as we’d like,” Beer acknowledges. “We experienced this in January and February of 2023 and we know exactly what we were missing.” DBi’s replication strategy lacked exposure to the Mexican peso and did not hold positions in the front end of the Canadian interest rate curve. “When managers think about these other positions, they often frame them as opportunities to generate more alpha due to the less liquid nature of these markets. However, these markets can be detrimental at the wrong time, leading to larger whipsaws and increased difficulty in unwinding positions,” considers Beer. DBi’s lack of exposure to the softs and other markets in 2024 resulted in a cost of only 200 basis points.

“When you miss, you don’t miss by much. Sometimes it hurts us, but in other periods such as this year, it works in our favour,” says Beer, highlighting that some trend-following managers have been “getting whipsawed on cocoa or facing challenging due to shorter-term models.” While the replication strategy may miss some trends in niche markets and there may be some noise in the strategy relative to the broader industry, Beer argues that “the hundreds of basis points gained in terms of fee and expense efficiency over time compensate for missing a few hundred basis points in rare market conditions.”

“When you miss, you don’t miss by much…The hundreds of basis points gained in terms of fee and expense efficiency over time compensate for missing a few hundred basis points in rare market conditions.”

Andrew Beer, Founder and a Managing Member of DBi

Another limitation of replication, as noted by Beer, is that DBi’s replication strategy tends to capture slower-moving trends. “This is a legitimate concern, especially in today’s market environment, which has witnessed some extremely sharp and vicious inflection points,” acknowledges Beer. “Many trend-following funds incorporate trip wires: volatility controls, stop losses, and other mechanisms to exit trend reversals early.” However, “these mechanisms assist certain funds during sharp inflection points about half the time. Just as some strategies may be de-risking, markets can quickly go through a very sharp U-turn,” Beer explains. 

“Our return profile resembles medium- to long-term trend following, which tends to be more stable and slower moving,” concludes Beer. “We argue that this is the true source of alpha generation in this space,” he continues. The shorter-term models and the volume controls may convey the message “Don’t worry, if we see the train coming down the track, we’re going to hop off before everybody else.” However, “we believe this approach often comes at the cost of long-term returns.”

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Eugeniu Guzun
Eugeniu Guzun
Eugeniu Guzun serves as a data analyst responsible for maintaining and gatekeeping the Nordic Hedge Index, and as a journalist covering the Nordic hedge fund industry for HedgeNordic. Eugeniu completed his Master’s degree at the Stockholm School of Economics in 2018. Write to Eugeniu Guzun at eugene@hedgenordic.com

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