Trend-following, the primary approach used in managed futures strategies, seeks positive returns by capturing momentum across major asset classes. While trend-following has generally delivered strong returns over multiple decades, its history of diversifying equity-dominated portfolios, especially in left-tail market events, has been its most prized quality. It is one of the few strategies to have excelled in the dotcom bust and financial crisis. In recent years, though, trend-following strategies have been less successful, partly, we believe, due to massive central bank interventions that have served to increase market correlations, suppress volatility and curtail left-tail events.
Now, however, the onset of Federal Reserve tapering and the possibility of heightened volatility suggest that trend-following strategies could once again be a valuable portfolio addition. Moreover, PIMCO’s approach to trend-following employs a number of modifications to the classic style that we believe make it especially well-suited to market conditions for the next few years.
A unique trading style
Trend-following can diversify traditional, equity-focused portfolios due to its unique ability to turn quickly and decisively short in any (and all) markets that are falling. By design, these strategies will always miss the turning point at the beginning of a downturn and initially take losses. But in most sustained equity market drawdowns, trend-followers have been able to reverse position and profit. Most trend-followers aim to detect trends between a few months and a year in length. For this reason they pair especially well with typical value strategies, which attempt to buy dips and sell peaks over the business cycle of five to seven years.
Trend-following strategies tend to benefit from a “right-skewed” return profile. The algorithms will typically stay in profitable trades until trends turn, avoiding the tendency to take profits too soon. Conversely, losing trades are unwound and reversed rapidly to follow the new trend. This rare profile, which tends to generate a large number of small losing trades, and a small number of large winning trades, is similar to long options positions (except for having an average historical return that has been positive rather than negative).
Figure 1 helps illustrate how these strategies managed to have an average negative correlation with equities and still produce positive returns over time. (Past performance, of course, is no guarantee of future performance.) It shows the correlation of a simple trend-following strategy (based on 20 futures markets) with the S&P 500 over rolling one-year windows. The correlation is -25% over the full 25-year history but is highly time-varying. It tends to be strongly negative during equity bear markets and modestly positive during bull markets, such that the strategy does not detract from, and may even add to, returns in normal market conditions. (Individual trend strategies will have distinct investment parameters and therefore different results. It is possible to lose money investing in a trend strategy.)
Trend-following strategies performed exceptionally well in the 2008 financial crisis. The years since have been markedly weaker, we believe, for reasons unique to the period. Although trend-following, like most strategies, appears to be cyclical and has experienced similar periods of underperformance in prior decades, there are factors specific to the last five years that may have contributed:
Central bank volatility suppression: Global markets over the past five years have been dominated to an unprecedented extent by central banks. Conceptually, trend-following performs best in periods of rising volatility, due to its option-like characteristics. Central banks have primarily been engaged in volatility suppression, often via direct interventions. The result has been an increase in abrupt trend reversals, especially during market downturns.
For instance, the simple trend-following strategy introduced above would have returned 11% while the S&P 500 fell 14% during Q3 2011, the peak of the European debt crisis. The beginning of the ECB’s decisive long-term refinancing operations in October 2011 reversed the plunge, sending the S&P 500 up 10% and the trend strategy down 12% in Q4 2011. PIMCO sees a gradual reduction in central bank interventions over the coming years and anticipates increasing levels of volatility as markets revert to fundamental valuations.
Increased correlations: Correlations across markets increased significantly over the 2008–2013 period, driven by a common risk-on/risk-off dynamic, possibly also related to central bank activism. As mentioned above, trend-following makes most of its profits on a small number of winning bets. When there are few independent trends to bet on, the strategy is naturally less effective. Correlations normalized markedly during 2013, however, as markets started pricing in the end of the Fed’s quantitative easing policy (see Figure 2). This should be positive for trend-following.
Overcrowding: Assets in trend-following strategies increased significantly after the crisis. While the markets in which these strategies are used are highly liquid, this increase has led to concern that trend-following may be overcrowded. We believe any such effect, reflected in more correlated positions, is likely to be stronger in strategies that use long-term trends of about a year or more.
Collateral returns: Finally, prior to the financial crisis, returns on the collateral that backs futures positions provided a substantial boost. Exceptionally low rates over the last few years have significantly reduced this tailwind. Strategies designed to boost collateral returns through active management may partly offset the impact of low rates.
PIMCO’s unique approach
Trend-following is a conceptually straightforward strategy, but like most investment strategies, implementation details are critical. PIMCO’s trend strategy has been developed over five years. It emphasizes the inherent diversifying properties of the approach and leverages the strengths of PIMCO’s investment process and infrastructure:
- Risk management bias: The strategy is designed to maximize its risk management role by constraining exposures that may add to traditional portfolio risks while leaving unconstrained the strategy’s ability to scale up rapidly in sell-offs.
- Scaling rules: We do not target a constant risk level, but rather scale up volatility as opportunities develop and scale down when market trends are few.
- Drag reduction: Optimization of carry in portfolios is a core PIMCO theme. The strength of a trend is weighed against potential drag from negative carry and roll-down.
- Execution and market knowledge: The specific markets and contracts PIMCO trades are influenced by our bottom-up and top-down research into numerous asset classes. PIMCO specialist desks execute trades, seeking to optimize transaction costs.
- Active collateral management: In an era of low “risk-free” returns, maximizing the potential from investing collateral through PIMCO’s active fixed income management can add a significant boost.
The likely tapering of the Fed’s asset-purchase program this year may mark the beginning of the end of a monetary policy regime that has weakened trend-following strategies. We expect correlations among asset classes will decrease while market volatility, returns and diversification potential will increase. In short, the trends are positive.