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With Trend-Following Funds Down Sharply This Fall, Should Investors Fish or Cut Bait?

Cambridge Associates

Fish, but only if investors can accept very lumpy returns. The SG Trend Index of ten large trend followers (e.g., Commodity Trading Advisors or managed futures strategies) fell more than 4% in both September and October and only matched cash’s return over the past five years. But volatility and frustrating performance droughts are not unusual for this category; investors will see this horror movie again. However, those that value uncorrelated returns and have not been unnerved by the painful recent performance shouldn’t be dissuaded.

After performing well in both the dot-com crash and the global financial crisis (GFC), trend-following funds began rapidly gaining assets, as investors gradually became comfortable with their rapid turnover, use of leverage, and counterintuitive (but academically grounded) approach of buying recent winners and shorting recent losers. Assets in these funds have more than tripled from 2009, reaching about $300 billion in 2016 and flatlining since then, according to Hedge Fund Research, Inc.

Investors that added trend-following funds to their portfolios during the years following the GFC had a variety of motivations. However, those that were attracted by strong performance may now be disappointed because performance for these funds is excellent when market trends persist, but it suffers when markets are choppy.

  • Uncorrelated to the stock market? Check.
  • Easy, liquid terms compared to most other hedge funds? Check.
  • Attractive risk-adjusted returns? Ummm…

While we believe the strategy can once again deliver appealing returns, it’s very unlikely that those returns will be dependable, even over rolling three-year or five-year periods. Trend following’s uncorrelated returns have historically been attractive, but they are lumpy rather than reliable. The SG CTA Trend Index’s quarterly returns have exceeded cash returns just 53% of the time since inception in second quarter 2000, while US equities and bonds have beaten cash during 67% and 69% of those quarters, respectively.

Investors that require more dependable investments should move away from trend-following strategies. Better to abandon now (with generally positive year-to-date returns), if an investor would feel compelled to sell based on trailing three-year or five-year returns falling below a particular threshold, for example. For those that may now be questioning the appeal, let’s examine the strategy’s headwinds.

Capacity Challenges?
While assets have swelled and fund leverage likely pushes gross economic exposure to more than $1 trillion, the industry is unlikely to dominate the very large markets in which these strategies operate (equity indexes, sovereign bonds, currencies, and individual commodities). As a point for comparison, daily turnover for exchange–traded futures contracts averaged $8 trillion earlier this year, according to the Bank for International Settlements.

Macro-Driven Markets?
Durable trends give trend followers time to feast, but choppiness is a challenge. Some investors believe that with markets now responding more often to presidential tweets and central bank twists than to fundamental economic or corporate developments, trend following’s time has passed. To this, we say, “maybe.” Consider that (a) geopolitical uncertainties aren’t a new development, and (b) some trend-following strategies are more adaptable than others (investors should consider strategies that blend multiple signal time horizons, such as medium-twitch and slow-twitch signals).

Bond Pressures?
Lower bond yields could be a performance limiter for trend-following funds, many of which hitched their wagon to the long bond bull market. We believe these funds have historically been long bonds perhaps 80% of the time. While the tailwind may not continue to blow, a prolonged increase in bond yields could still prove profitable for trend followers. That said, if the strategy isn’t reliably long bonds, it may be somewhat less effective as an equity diversifier going forward.

The Bottom Line
If recent returns are too much to bear, investors should probably move on because undependable returns are a longtime feature of trend-following funds. They are non-correlated and liquid, but they frequently disappoint.