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Trend following in the time of COVID-19 PHILIP SEAGER Head of Strategy - Quantitative Investment A strategy that can improve outcomes Solutions, CFM and reduce downside risk – if done right

nstitutional investors hit by the COVID-19 pandemic placent, and then it all ends in tears when there’s a crisis. and resulting sell-off in global equity markets may be People buy into trend following after the spike and are then Long term, a mix of equities scratching their heads, wondering what they could have disappointed by the subsequent often long periods of mod- Idone differently. Traditional risk-hedging strategies, such as est performance.” with diversifying and using options, buying low volatility/quality stocks and others, were either costly or not effective. Disciplined trend following can offer a Sharpe ratio in line defensive strategies such as with a buy-and-hold equity strategy but with uncorrelated “Based on discussions I’ve had with institutional investors, a drawdowns and some protection in extreme equity sell-offs. lot of them have tried to employ defensive strategies,” said According to Seager, the skewed performance patterns of trend following should give Philip Seager, head of strategy - Quantitative Investment equities, with infrequent yet severe sell-offs, means investors Solutions at CFM. “And those defensive strategies are gener- often forget about the need for diversification. An allocation better outcomes. ally based on complex option baskets. What we’ve generally to trend following can diversify a portfolio. found with options is that the premium to employ these strat- egies is very high. What that means is essentially you end up For many investors, trend following can be difficult because, with a long-term negatively dragging P&L.” as Seager put it, “you get prolonged periods of not much Over the long term, investors using trend following as a re- happening. But then you get the occasional spike upward.” turn enhancer should expect a net Sharpe ratio of about What’s more, the premium goes up when markets go down. 0.5. Research by CFM has found that gross returns from a Here’s how trend following can work. Consider the fact that a six-month trend follower have never been negative in any “Think about when you’re buying insurance,” Seager said. “If random walk of markets is by definition unpredictable – the historical 10-year period, unlike equities.2 you’re trying to insure your house or your car, you never buy long-term P&L of any strategy applied to it has to be flat. But insurance thinking that it’s going to be a long-term winning it can fluctuate upward for several consecutive periods or In addition to equities, trend following has shown to deliver strategy, but it is a positively skewed strategy. So when you downward for several consecutive periods, in a statistically statistically significant excess returns in asset classes make a claim, it pays out. But the premium you pay is fairly insignificant manner. The trend follower can still come out ranging from commodities to currencies to stock indexes to high. The premium gets higher the more people want insur- ahead over short, statistically insignificant periods, hence bonds, over very long-time series. ance and when the number of claims increases.” the convexity or protection against big moves. For equity investors, say a pension plan that is a long-term One investment strategy not commonly considered as part “Even a random price can sometimes drift strongly up or investor seeking to maximize risk-adjusted returns, rather of a risk mitigation arsenal but that can provide significant down and when that persists then the trend follower makes than allocating 100% of the risk budget ― or, more narrowly, downside protection without the drag of a hefty premium money — more and more if a crisis persists,” Seager said. the equity budget ― to stocks, 20% could be allocated to during periods of drawdown is trend following. CFM has investigated this statistical phenomenon in a math- trend following and the rest to equities. ematical research paper.1 “The remarkable thing about trend following is that you get “What you’re essentially doing is getting the same level of that positive skew, albeit on long timescales, but you do not “We’ve done a lot of work on trend convexity, which is a risk-adjusted returns with less volatility and, therefore, less seemingly get the negative P&L drag,” he said. “Based on mechanical effect,” he said. “If one applies a trend-following draw down,” Seager explained. “That’s really what you’re very long-term back tests, it seems to have a modestly pos- approach to a random walk price time series then there is achieving. And I think that is something most people would itive Sharpe ratio.” protection against big moves up and down.” be very happy about.

The underlying problem is that investors are humans and as The coronavirus-driven market sell-off brings any strategy’s “Throughout the cycle, the smart investor is diversified in such they have a penchant to follow trends, which makes protective features into sharp focus. “At CFM, we’ve relied risk-on and defensive strategies — a mix of equities with a di- them stray from ― and forget about ― diversification and the upon trend following historically as a performance driv- versifying and defensive allocation to trend following should benefits it brings in both down and up markets. Also, they er, and we, and many others, have realized that improving give better outcomes,” he said. “It is never too late to adopt tend to be undisciplined or, in other words, performance risk-adjusted returns comes at the expense of reducing con- trend following.” ▯ chasers. vexity. Based on discussions with clients, we have found, however, that there is a demand for convexity and protection. “If you’re undisciplined, and a performance chaser, then you We therefore now have two products ― one trying to get sponsored by: tend to buy into an investment after an increase in perfor- the highest risk-adjusted returns and another strategy that mance,” Seager said. “Trend following is somewhat difficult is trying to get the most out of trend following in terms of for investors that inherently exhibit this behavioral bias to convexity that then delivers slightly less in terms of Sharpe chase performance. People hold equities, they become com- ratio,” Seager said.

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1“Making Fat Right Tales Fatter with Trend Following….most of the time.” CFM. November, 2018. https://www.cfm.fr/assets/Uploads/PDFs/2018-Making-fat-right-tails-fatter-with-trend-following-most-of-the-time.pdf 2 Y. Lempérière, C. Deremble, P. Seager, M. Potters, J. P. Bouchaud. “Two centuries of trend following,” Capital Fund Management, Paris, France. April 15, 2014 https://www.cfm.fr/assets/ResearchPapers/2014-Two-centuries-of-trend-following.pdf Any description or information involving investment process or allocations is provided for illustration purposes only. There can be no assurance that these statements are or will prove to be accurate or complete in any way. All figures are unaudited. This article does not constitute an offer or solicitation to subscribe for any security or interest.

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