Systematic Trading research and development, with a flavour of Trend Following
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Trend Following returns breakdown

July 1st, 2010 · 4 Comments · Strategies, Trend Following


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:

  1. T-Bill returns on marginable assets
  2. Static returns from trend-following futures markets
  3. Rebalancing gains

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…)

Further breakdown

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”:

  • spot price beta move
  • roll yield

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.

  1. T-Bill returns on marginable assets
  2. Returns from trend-following spot price beta moves
  3. Roll yield
  4. Rebalancing gains

Roll Yield: a misnomer?

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.

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4 Comments so far ↓

  • Pumpernickel

    Obviously the partitioning of total profits into these four categories is a function of the average trade duration. For the MLM index, average trade duration is hundreds of market-days; each trade is rolled over & rebalanced several times.

    However, quite a few very large CTAs have very short average trade duration (less than 10 days). There’s even an index of them: including research papers etc.

    Down at this end of the spectrum, with average trade duration of 5 days, roll yield and rebalancing gains are negligible. The histogram bars in your chart above contain no ivory and no maroon: what explains the returns of the MLM Index, does not explain the returns of Crabel Asset Management.

    Finally, it should be remembered that CTA *managed accounts* generally do not have T-bill returns on marginable assets, and the reported performance of CTA managed accounts generally does not include T-bill returns. Managed account clients can, and usually do, move the free cash out of the futures account and into other investments. They stand ready to meet a margin call, if any; but not by keeping every dollar of the notional account size in the futures account. MLM incorrectly assumes that all trend following trading takes place in *futures funds* (aka “commodity pools”) like their own, where notional account size equals actual account size, and excess cash is available for Tbill purchasing. It ain’t so. Particularly in the post-Madoff era, managed accounts are very popular with institutional clients, because the CTA doesn’t control the money; only the trades.

  • Jez

    Very good points well made Pumpernickel..

    For “roll yields”, I wanted to highlight the fact that this was not merely a side-effect of rolling contracts, but rather of the futures price gradually converging to the spot price – and on that basis would affect all trades, even a trade lasting 5 days. Doing 20 long (direction) trades of 5 days and one trade of 100 days should suffer the same contango premium deflation (at least in a absolute – the relative cost of the roll yield would be dependent on the risk/reward profile of the trades and risked capital per trade). Of course, shorter-term systems would probably be more direction-neutral and suffer/get rewarded less by roll yield.

    Regarding T-bill returns, I do feel that, as an investor (whether through Managed Accounts or self-trading), you’d want to put aside a liquid, stable “cushion” to cover worst case scenarios (trading at Max MTE or during drawdowns for example). Instead of holding extra Cash, T-Bill seems a “safe”, liquid and return-bearing instrument for this – which is why I think it still offers some relevance for an investor considering the global returns of a Trend Following strategy (or any other futures/margined strategy). The amount for that liquid cushion depends on the characteristics of the trading strategy (MTE, drawdown stats, etc.).

    But thanks for raising the point/clarifying the idea of CPO/funds vs. CTA managed accounts or self-trading (where the latter options offer more options than a fund where account size = notional size). I guess, trading outside of a fund structure would allow you to be more sophisticated by also holding less liquid assets and covering additional margin requirements by punctually getting loans collateralized by these less liquid marginable assets – or even simply doing notional funding.

    I guess this is what you were pointing to?

  • Sam Humbert

    Link to “previous post on backwardation, contango and crude oil” is broken.

  • Jez

    Cheers Sam – thanks for letting me know – fixed now.

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