Following the previous post on backwardation, contango and crude oil, let’s look at how several factors can play a part in the overall trend following trading system performance.
I have previously referenced the study by EDHEC Risk, which shows the different sources of return of a Trend Following strategy.
The authors build the Mt. Lucas Management (MLM) index, which applies a 200-day moving average Trend Following strategy to a diversified range of 25 futures markets, rebalanced monthly. The performance of the index is separated in three periods and further broken down by the three individual sources of return identified by the authors:
The chart below shows the representation of each component’s participation to the overall return:
You might find it surprising how relatively small the impact of the actual Trend Following strategy return is (I know I did…)
The previous post highlighted that the performance of any Crude Oil futures contract was unable to match the performance of the spot price (despite a fairly high beta of 0.83). This is mostly because holding commodities via futures contracts expose you to the spot price beta move (as mostly anticipated) but also to the yield curve of that futures contract.
Over time, the impact of the backwardation or contango in the yield curve (roll yield) can create a large drift between the actual spot price performance and the equivalent futures contract.
This is very apparent in a simple “buy-and-hold” example (as in the Crude Oil case) but the same would apply to any trading strategy using futures instruments. Any futures trade could be broken down into two “components”:
And therefore the sum of all the trades resulting from a trading strategy (such as Trend Following) could fall into these two same categories, giving us now four overall components.
Note that Roll yield is not aptly named; it implies that the act of rolling contracts yield a specific return. However, the return resulting from contango or backwardation is merely “crystallized” at the time of rolling contracts: the contango premium (backwardation discount) actually deflates over time gradually.
For example, think of buying a Crude Oil contract at the beginning of the month with a premium over spot of $1 per barrel (at $76). If the spot price does not change during the whole month, the price of the future contract simply converges to the spot price ($75) – the premium simply deflates. When selling the contract at the end of the month, you will have lost $1 without doing a contract roll and with the price having stayed stable.
Breaking down the actual components of a global strategy might be helpful in order to understanding the sources of returns and focus on a specific one to possibly improve it and enhance the overall system. For example, a more sophisticated approach to rolling contracts might enhance the overall roll yield produced by the trading strategy.