During the past few years the topic of alternative investing has become popular among the broader asset allocation community. That said, many of the investors we talk to about alternatives generally have been dissatisfied with their performance. Reasons cited for this frustration often include the general underperformance of the strategies versus large-cap U.S. stocks since the financial crisis, lack of transparency, illiquidity and high fees. While there is certainly some legitimacy to investors’ frustrations, part of the issue lies in a general lack of clarity with respect to the role alternatives are intended to play within a portfolio. We generally think of alternatives either as offering diversification benefits that generally cannot be accessed through more traditional, long-only allocations to stocks, bonds or commodities, or as a source of excess return over those more traditional market exposures that emanates from the manager’s insights or information advantage.
Managed futures strategies generally are touted as one of the more diversifying alternative investments based upon their potential to offset equity, credit and commodity risk by going both long and short underlying markets.
The potential to be short during a general market decline can prove to be a valuable tool. Within the broader category of managed futures strategies, trend following, in particular, has provided a meaningful source of diversification during periods of crisis, which is when investors have the greatest need for diversification. There has been a renewed interest in trend-following strategies alongside dedicated U.S. Treasury portfolios and certain tactical trading strategies that the institutional community has collectively described as crisis risk offset or risk mitigation strategies.
The California State Teachers Retirement System (CalSTRS), the nation’s second largest defined benefit plan, announced that it is going to allocate $16 billion, roughly 9% of its portfolio, to such strategies — 40% of that to trend following — in an effort to dampen overall fund volatility while reducing the severity of drawdowns. In December CalSTRS announced it had increased allocations to AQR and Graham Capital to $500 million.
As institutions begin to covet the non-correlation attributes of trend following, there also is a desire to access it in a structure they understand. For those unfamiliar with managed futures, sifting through hundreds of strategies, most of which generally can be referred to as medium- to long-term trend following, but all with unique attributes, this can be daunting. The question is, can trend following be reduced to a beta, an index that can be checked in a broader portfolio shopping list?
Intuitively, trend following strategies fall into the category of crisis risk offset based on their ability to short markets during periods of declining trends. By contrast, we wonder whether U.S. Treasuries — or the sovereign debt of any developed market — will offer the same level of diversification it has in the past, given today’s low interest rate environment that has been promoted by coordinated central bank policies. While we expect the direction of interest rates to remain positively correlated with the direction of equity markets, we do not believe that investors will enjoy the same upside they have in the past based solely on the premise that interest rates cannot go substantively negative for an extended period. The value of trend following can be seen in the historic performance of various markets (see “Return driver,” below).
Trend following strategies are based on the simple premise that markets tend to trend and will continue to move in an established pattern during various holding periods. The best argument for why this works is based on the notion that investors do not assimilate information as efficiently as they should. The process of information assimilation may be described as follows: (1) the importance of new information is initially met with investor skepticism until (2) the new information is confirmed by further evidence causing investors to gain confidence in the relevance of the information, which (3) culminates in an overconfidence in the permanence of that information. As investors move from skepticism to confidence to overconfidence, a trend is formed.
Trend-following strategies offer an important complement to long-only portfolios as they can serve to tactically overweight the attractive elements of a portfolio during rising markets and lower exposure to assets that are under pressure in declining markets. For this reason, Salient designed its Trend Index to access the same investment opportunity set as the core portfolios they are intended to complement. In other words, trend-following portfolios that include stocks, bonds and commodities tend to offer the best complement to long-only portfolios that contain stocks, bonds and commodities. Strategies dominated by currencies and short-term interest rates generally offer less downside protection relative to traditional stock, bond and real asset portfolios than the strategies that simply focus on stocks, bonds and real assets, though all tend to offer non-correlation.
“Portfolio builder” (below) shows the correlation of the Index to stocks, commodities, credit and sovereign bonds across all market environments and during periods when those markets lose more than -5% in a given month.
This Index was specifically designed to represent a trend-following strategy that offers significant downside protection relative to equity markets when equity markets are down significantly. The Index is entirely rules based, targets a 10% annualized standard deviation of returns, weights each position in proportion to its signal and includes a broad sampling of 56 different equity, commodity and sovereign debt instruments. The focus on this broad sampling of instruments in a risk-weighted framework maximizes the breadth of decisions made within the portfolio. Because any single decision only has a small edge, we find that it is useful to make a lot of decisions simultaneously, which results in higher risk-adjusted performance and consistency. The advantages of the index-based approach are found in its low cost of implementation, systematic design that leads to predictability, breadth and opportunity set that was selected to offer the greatest level of diversification to equity and credit markets when those markets are experiencing their greatest drawdowns (see Filling a niche,” below).
A number of managed futures strategies have benefited from a declining interest rate environment that has persisted since 1982, which have resulted in bonds generating the highest risk-adjusted returns of the four major asset classes while providing significant diversification for equity and credit centric investors. Even though interest rates will likely remain low for a long period, today’s low starting yields leave little potential for bond price appreciation and the next large move in interest rates will likely be higher — whenever that occurs. Accordingly, the diversification benefit that bond-heavy managers have offered in the past may be less certain in a world where the upside of bonds is limited by today’s low starting yields and many managers will have a bias toward shorting bonds in a rising interest rate environment. Said simply, short bond positions are unlikely to offset equity risk during periods of crisis. In contrast, managed futures generally, and the Salient Index specifically, weights individual positions rather than asset classes and comprises 23 equity markets, 24 commodity markets but only nine sovereign debt markets. Because assets are individually weighted, rather than asset class weighted, equities and commodity markets generally will have a significantly greater impact on strategy returns than will sovereign bonds.
The potential drawback of choosing a trend-following index is that it is intended to extract an identifiable risk premium from the market that corresponds to trend following. No index imbeds the insights of a manager nor does it purport to have any information advantage over what is detectable from past return patterns. By contrast, there are a number of active managers who offer strategies that incorporate a broader set of decision variables including fundamental factors, mean-reversion, value, carry and even flows. In some cases, active managers can build a mosaic of information that may come from publicly available sources that are not readily accessible to the average investor in a timely and actionable form.
Active managers often have greater dispersion among their peers or reference indexes based on the individual insights and the methods they employ. Stated simply, active managers have the potential to translate insights into returns. Some of the objections to active managers relate to high fees and lack of transparency. We strongly believe that incentive fees can be used to align the interest of asset owners and asset managers if two conditions are met. First, incentive fees should be paid for the value added over and above any passive market and/or systematic exposures imbedded in the strategy. A number of commodity trading advisors (CTA) fail to achieve that objective due to their reliance on more straightforward trend following and mean-reversion strategies that are laden in their portfolios.
Second, diversification in a multi-manager portfolio can weigh on net portfolio returns in the absence of fee netting. Consider a portfolio that is perfectly diversified across two managers who are perfectly negatively correlated with one another. If each receives a 20% incentive fee for the gross (or net of management fee) returns, the structure itself suggests that the asset owner will always pay the winner, but will be unable to reclaim fees from the loser. In a world where one manager is up 10% gross and the other is down 10% gross, the allocator will earn a net portfolio return of -1% less the management fees, as the gross return of the positive returning manager is reduced to 8% after incentive fees.
Nevertheless, for strategies that involve more nuanced trading approaches, access to smaller markets, high technological barriers to entry or true information edges, the fees may very well be worth it. Most allocators would jump on the opportunity to access Renaissance or the equivalent regardless of fees. Absent those characteristics, more passive approaches like the one represented by the Salient Trend Index and other products attempting to capture the beta of trend following may serve as an effective, lower cost solution for investors who are primarily interested in the diversification benefits of trend following as a strategy.