No free lunch – earning money with price trends

The trend is your friend… …until the end when it bends” – price trend trading has been an established, successful long-term investment strategy on financial markets for decades. This year, however, managed futures strategies that bet on long-term trends have repeatedly gotten caught on the wrong foot and stopped out by abrupt reversals in market direction. The latest episode, though, is less a change in regime and much more an entry opportunity. Trend-following strategies generate added value in a portfolio context in the long run, but that doesn’t come for free – it, first and foremost, costs patience and discipline.

Managed futures under the spell of tweets

Donald Trump has been posting more than ever on social media in his tenure as the 47th US president. Although it’s easy to overrate his actual influence over financial markets, it cannot be denied that the USA’s political course during Trump’s second term in the White House has already left a number of conspicuous marks on them this year, including a temporary nosedive on the equity market, intense bond-yield volatility, and an extremely weak US dollar. Whether causal or coincidental, the presidential inconstancy and the ensuing abrupt changes in price directions in many asset classes have been very challenging for trend-following managed futures strategies. That’s because trend followers need trends – sawtooth markets (with jagged ups and downs in rapid-fire succession) or quick reversals in the style of V-shaped recoveries (like the ones that occurred in April and May on the equity market) are the worst conceivable environment for them. So very bad, in fact, that the stock-price movements triggered by Liberation Day caused the SG Trend Index, which tracks the performance of the ten largest trend-following managed futures funds, to experience one of its largest drawdowns (–20.8% peak-to-trough) in its more than 25-year history.

Highs and lows | Returns on trend-following strategies are cyclical

Rolling 1-year performance of SG Trend Index

Sources: Bloomberg, Kaiser Partner Privatbank

Crisis or correction?

For those invested in managed futures, this development was both painful (due to the asset price losses) and disappointing (due to the failure of the hoped-for insurance protection against weak stock markets to materialize). It wasn’t unusual, though, because like most other asset classes or investment styles, the performance of managed futures is cyclical – after it rains the sun shines again, and vice versa (see chart above). And the missing parachute function also isn’t an anomaly, but instead follows a pattern that was last observable during the COVID-19 pandemic: to wit, classic trend-following strategies deliver protection only against prolonged crises like the 2022 bear market, the 2008 financial crisis, or the aftermath of the bursting of the technology bubble in the year 2000, for example. In the face of shorter-term corrections lasting less than a half-year, they in contrast are too slow-acting to adjust to and profit from new (downward) trends (see chart below). It’s not the emergence of a trend, but its maturation that is the real source of return for trend-following managed futures.

When the damage is longer-lasting… | …trend-following strategies provide good insurance

Performance of trend-following strategies during (US) stock-market corrections exceeding –5%, since January 1, 2000*

*The size of the circles reflects the magnitude of the positive (blue) or negative (gray) performance of trend-following strategies.

Sources: Bloomberg, Kaiser Partner Privatbank

A proven diversifier

So, nothing new then. Investors therefore shouldn’t furrow their brows unnecessarily deeply in worry. Managed futures strategies, in fact, actually rank among the most tested and intensively scrutinized alternative investment styles by analysts in the history of securities exchanges. While the beginnings of managed futures hark back to the advent of commodity futures trading, as illustrated by the name “commodity trading advisor” (CTA) still commonly used today, the adoption of the modern multi-asset approach by institutional investors began in the 1970s. Since then, managed futures have systematically profited from both rising and falling prices across a broad investment universe ranging from stocks and bonds to currencies and natural resources. CTAs have proven their added value for an investment portfolio again and again in recent decades. The added value is based mainly on a low and partially inverse correlation to the performance of traditional asset classes (see table below). In recent years in particular, a period that has seen a renewed increase in synchronism between stocks and bonds (positive correlation), this property of CTAs has been especially valuable.

A genuine diversifier | Trend followers deliver added value to an investment portfolio

Correlation matrix, data from January 1, 2000, onward

Source: Bloomberg, Kaiser Partner Privatbank

A good entry point?

However, this very same property also has its pitfalls because the uncorrelated returns generated by managed futures are often at the same time counterintuitive to the human psyche. Trend-following strategies can fall behind and underperform traditional assets during torrid (equity) bull markets and when trends abruptly get interrupted. The frequently observable periods of flat or negative performance are also psychologically challenging. They test an investor’s conviction and raise the issue of potential opportunity costs. But even if episodes of that kind sometimes cost an investor a lot of sweat and nerves, on the flipside of the coin a “patience premium” beckons in the form of above-average returns after periods of market weakness or after major drawdowns. In this sense, there’s a lot suggesting that patience with trend-following strategies will pay off again. Each of the nine largest drawdowns in the SG Trend Index since its inception has been followed by a double-digit percent gain over the subsequent year, with only one exception (see chart below).

After it rains… | …the sun usually shines again

SG Trend Index’s ten largest drawdowns (and subsequent one-year performance)

Sources: Bloomberg, Kaiser Partner Privatbank

But managed futures are more than worth taking into consideration right now not just on the grounds of the statistics. Trend-following strategies have become attractive again in the 2020s also because the era of globally coordinated monetary policies (read: negative interest rates and quantitative easing), which compressed risk premiums, distorted prices, and constrained profit opportunities for managed futures, is over. Cash has resumed earning interest ever since (except in Switzerland). This, too, directly benefits an investor’s performance: since trend-following strategies typically trade liquid futures or forward contracts that require little upfront collateral, that enables a large part of the fund assets to be invested in interest-bearing securities.

Tips & tricks

Here’s a tip and a trick for those who, despite the good prospects outlined above, find fault with this year’s “claims event” with managed futures and are grieving over their missing insurance payout. The tip: There are other “insurance strategies” besides managed futures that offer protection against falling prices on equity markets. (Put) option-based strategies and tail hedge strategies, for example, have become increasingly popular among investors. Both quite reliably deliver the desired protection if stock prices tank in a short space of time like they did in April. However, one pays a high price for that instant protection – in the form of negative returns during calmer market phases and across lengthier cycles. Trend-following strategies, in contrast, provide protection only during prolonged bear markets and require patience and discipline, but in exchange they generate an absolute (positive) return over the long run (see chart below). The trick: Diversification – so, nothing new here again. But what’s meant is diversification within the managed futures universe. Besides strategies that follow long-term price trends in traditional asset classes – the strategies that are the main focus of this article – there are also ones that bet on short-term price trends. They have been joined in recent years by trend-following strategies on alternative to even exotic asset classes and on economic trends. It seems to be a law of nature that the financial industry never stops innovating. Trends are just as much a law of nature – they are embedded in the (immutable) crowd psychology of market participants.

Insurance with low opportunity costs | CTAs can also profit during recovery phases

Performance of trend-following and put strategies during (US) stock-market corrections

Sources: Bloomberg, AQR, Kaiser Partner Privatbank