AQR is a top hedge fund, managing around $24B in Assets. Lately, they have been making noise about their moving into the Managed Futures space (a.k.a. Trend Following). They seem to be working at institutional investor’s acceptance of trend following as an “investment” concept. They might just be trying to catch up with another mammoth hedge fund: MAN who have been strong in this space since taking AHL over.
A research paper (summarised below) was recently published by AQR, explaining some concepts of trend following.
Clifford Asness, AQR Managing & Founding Principal, was also invited to speak about it with his good friends at CNBC (he is also an ex-Goldman, so he surely has lots of connections with the media and government). The video is not that interesting but here it is below, anyway. If you’re short of time (aren’t we all?), I recommend you skip to the paper (8 pages) or the summary, which yield more interesting insights.
Summary of Paper: Understanding Managed Futures
- They start with a chart displaying the Managed Futures “smile”, basically a scatter plot of Trend Following strategy return vs. S&P 500 total return – making the point that Trend following performs best in case of extreme stock market moves (one of the main points they want to drive home throughout the paper is that Trend Following is a great portfolio diversificator with low correlation to other assets). They further empirically demonstrate this by pointing out Trend Following’s performance in Q4 2008 (strongly positive) in contrast to the global crash.
- The paper uses a hypothetical Trend following strategy for comparison and analysis. This strategy trades 60 liquid futures markets divided in the four asset classes defined by AQR (equities, commodities, bonds and currencies). To determine the trend, the strategy considers the excess return over cash of each instrument for the prior 12 months (a positive return results in a long position and a negative return results in a short position). The portfolio is equal-risk-weighted (i.e. normalised for annualised volatility) across the instruments and rebalanced every month.
- The second part breaks down the three parts of a trend and some behavioral biases or technical explanations for them:
- Start of the trend and under-reaction, due to anchor and insufficient adjustment to new conditions (i.e. news, supply shock, etc.), disposition effect (selling winners too early) and market particpants fighting trends (central banks or commodity hedgers)
- Trend continuation and over-reaction, due to herding and feedback trading as well as confirmation bias (similar to the reflexivity concept explained by George Soros in The Alchemy of Finance) and Risk Management practices (stop losses being triggered generate more losses, etc.)
- End of the trend where the market comes to the realisation that prices have gone too far
- The analysis of the strategy looks at the performance of each market and compares it to the overall strategy performance – noting the effect of the free-lunch that is diversification: The Sharpe ratio of the overall strategy is 1.3, higher than any of the individual market Sharpe ratio (all between 0 and 1).
- Another observation is the low correlation between the individual markets (average pair-wise correlation of 0.08) as well as between the overall strategy and various asset classes (Equities, Bonds and Commodities).
- Finally, they compare a 60/40 portfolio performance (60% Equities, 40% Bonds) with a hybrid portfolio (80% 60/40 portfolio and 20% Managed Futures) and show that return, standard deviation, Sharpe ratio, worst month and worst drawdown are all improved under the second scenario. I believe this is how they intend to market their new trend following funds: as a portfolio diversificator improving its overall variance-adjusted return
- In conclusion they highlight some of the risks (range-bound periods, high turnover and trading costs as well as manager fees) and finally (it is a marketing paper after all!) some of the value-add that a fund like theirs can provide (advanced strategies using rigorous quantitative methods over different time horizons, sophisticated risk management systems, portfolio optimisation and smart order execution algorithms, etc.)
The trend following space is just getting a bit more crowded…