Observations on the death of trend following

 “The reports of my death have been greatly exaggerated.” Mark Twain

The weak performance of commodity trading advisors (CTA) the last five years begs the question “are trend following strategies still profitable?”

In 2012, the aggressive and persistent actions by central banks and other authorities worldwide served to maintain an unfavorable market environment that began in 2009 for most trend following systematic programs. Many short, medium and long-term trend following CTAs, as well as other trend following hedge fund strategies performed poorly. Nevertheless, equity and futures markets experienced sizable moves.

By the end of 2012, indexes measuring CTA performance, the Barclay Btop50 Index (-2.0%), Newedge CTA Index (-3.1%), Newedge Short-Term Traders Index (-6.2%) and Newedge CTA Trend Sub-Index (-3.6%), had all given back earlier gains. While these indexes all reported losses for the second year in a row, the S&P500's climb (+13.4%) continued through year end. Although markets for hedge funds generally were better than for CTAs (barring the last couple months for quantitative based hedge funds), the HFRX Global Hedge Fund Index rose only 3.5% in 2012.

This performance contrasts sharply with longer term numbers, particularly in the CTA space. Since 1980, as measured by the Barclay Hedge Btop50 Index of CTAs, managed futures have returned three times that of the S&P500, approximately 32 times an initial investment vs. 11times an original investment for the S&P 500. And in 2008 the S&P was down 45% while the Btop50 was up 14%. However, the Newedge Trend Following CTA Sub-Index is down 5.89% since the bottom of the financial crisis in March 2009. Recent flat to down CTA performance differs markedly when compared to average performance of about 6.0%/yr. from 1990 to 2000.

In contrast, from 2009 to May 2013, the S&P has rocketed about 130%. Yet many equity managers have not fared so well given the huge S&P tail wind; and during the four years following the stock market crash, investors have fled stocks in droves while embracing managed futures mutual funds, which are commonly trend following programs. It seems investors are miss-stepping everywhere they tread.

Not dead yet? 

In light of such poor performance many CTAs and their panicked marketing agents continue to publicly argue that trend following is not dead. While the four- to five-year drawdown that many otherwise successful commodity and currency managers have experienced continues to wreak havoc with long-term track records, more and more of these battered traders are emphasizing that everything will be okay. Likewise, hedge fund managers representing various strategies believe they must stay the course and markets will sort out.

On the other hand, investors have increasingly come to believe that trend following is no longer profitable and their reasons are plentiful: market-moving government rhetoric and intervention – with forced suppression of interest rates, central bank policy change, high-frequency trading, a proliferation of commodity and currency-based ETFs, together with very large CTAs and hedge funds who throw around billions of dollars in the commodity space. So, what is contributing to such mass underperformance by so many managers?

Simply stated, trend following is at its core a long-volatility strategy. In other words, it makes money when volatility expands (i.e. during trending moves). Conversely, it suffers frequent but small losses during non-trending periods in exchange for such infrequent but large gains. During non-trending periods the strategy attempts to tread water through the judicial use of stop loss orders until some market movement provides a large outlier move in which the strategy can profit.

While the complexion of markets frequently changes, since 2009 markets traded by CTAs have been in a prolonged period of non-trendiness combined with a great deal of volatility. Managers who trade U.S. equities, while taking comfort in upward moving stock markets also have been subject to more volatile moves in both indexes and individual stocks. But what are the underlying factors that currently impact investable markets with a goal of better comprehending manager strategy and limitations.

Very few systems are profitable in all markets. Hence, it is generally agreed that a robust approach is far superior to an overly optimized one. Historically, together with prudent risk management the robust trading methodology has a far greater chance of surviving the rough patches. Thus, to make their programs truly robust, many CTAs use 25 years of data. Further, they overlay risk management and manager-specific rules to the purely quantitative portion of the trading program.