Book Review: Trend Following with Managed Futures

Trend Following with Managed Futures: The Search for Crisis Alpha. 2014. Alex Greyserman and Kathryn Kaminski.

Price-based investment strategies have come a long way since 25 years ago, when the consensus was that markets were weak-form efficient, with past prices being unable to tell us anything about future behavior. Investors are warming to this active investment style approach, even though trend following has often been associated with “noise” traders and theoretical technical analysis. Some consider the empirical evidence supporting momentum trading to be an empirical puzzle that cannot be reconciled with theory, yet it has become such a popular topic with some finance researchers that it is referred to as the fourth factor alongside the market, size, and value factors of the Fama–French three-factor model.

Discussion of price- or return-based strategies has involved two types: momentum, the ability of past return performance to tell us something about relative future performance; and trend following, the ability of past prices to tell us something about absolute future price performance. This distinction is somewhat exaggerated when, in fact, the foundation is the same: Past price or return patterns have memory and will continue in the future, albeit with reversals in the long run.

The shift in thinking and the empirical support for trend and momentum trading have been growing steadily. Still, it is hard to pursue trend following as a pure investment style except through commodity trading advisers (CTAs), who are also broadly classified as managed futures funds. The style, trend following, and delivery mechanism, managed futures, have been inextricably tied together since the first CTA funds were launched. Hence, this new book by Alex Greyserman of International Standard Asset Management and Kathryn Kaminski of SIFR (Institute for Financial Research) on trend following and managed futures is timely and important; it provides a strong theoretical and empirical foundation for the strategy and the hedge fund delivery mechanism.

Little has been written about this style for the trained financial professional. (One of the best single sources of information on trend following is author Michael Covel’s website.) A significant number of books have been published on trend following, but Trend Following with Managed Futures: The Search for Crisis Alpha changes the standard for the discussion by using the language and analytical techniques of empirical finance to fully analyze the case for this strategy. Language and the method for marshaling evidence matter when advocating to a specific audience. This book provides the context and empirical evidence to make almost anyone who was trained in a master’s finance program accept the efficacy of trend following. The authors’ exhaustive analysis details every aspect of how trend following is used in an investment program. It provides a clear road map for discussing and analyzing an alternative investment style.

Actually, this work is two books in one. The first is a discussion on trend following as an effective active management strategy along with the rationale for its success. The second is a discussion of how to compare CTAs — managed futures funds — and show their effectiveness in a traditional portfolio. Each topic could have been developed separately, but together they provide a strategic foundation as well as a broad method for fund analysis.

The authors begin by recapping the impressive success of trend following through the centuries across a wide set of asset classes. This review demonstrates that this simple form of active management will outperform a long-only approach. The advantage is consistent across interest rate and inflation environments. This strategy reduces maximum losses or drawdowns and does better in bad times. Trend-following performance may ebb and flow with market cycles but proves effective over the long run. But as regulators like to have managers say, past performance is not indicative of future success. An obvious issue with this work is that the portfolio tested could not actually be mimicked in the marketplace. There is a difference between showing what a bundle of assets using this strategy would have done and investing in a tradable portfolio.

To support their claims, the authors put forth much effort to explain when and the reasons why trend following will generate returns, based on MIT professor Andrew Lo’s adaptive markets hypothesis, an evolutionary model that includes adaptation and competition to explain market efficiency. The authors also present the concepts of divergent trading and crisis alpha to increase the reader’s understanding of trend following. The strategy should do well when markets are in periods of dislocation (i.e., diverging from past equilibrium prices). Longer-term trend following is “mean fleeing” and should generate good performance when market volatility is high, in contrast to periods of convergence, when markets return to some equilibrium level. Both divergent trading and crisis alpha may lead to trends, but market divergences create the longer-term, larger moves that can make trend following profitable as a long-term strategy.

The authors discuss and measure crisis alpha, or the return from trend-following strategies when equity markets have a significant downside move. Crisis alpha is the amount of excess return generated in a down market event. It is a nice turn of phrase for the negative correlation of managed futures at market extremes, but whether it identifies a true skill or a repeatable style based on selling markets short and allocation avoidance is up for further discussion. The return evidence does support trend strategies that can switch direction from long to short and dynamically adjust asset class allocations during times of market dislocation. Greyserman and Kaminski want the reader to conclude that trend following constitutes an alternative asset class, given its unique characteristics with respect to drawdown and correlation. Uniqueness of style is a given; however, designating trend following as an alternative asset class may be a stretch.

The authors’ rationale for the effectiveness of trend following could have been developed further. Trend-following efficacy can be found through such concepts as rational herding, noise filtering, and volatility avoidance. Trends often exist because of behavioral biases, slow reaction to uncertainty, or dispersion in investor beliefs. These concepts make a strong case for the slow reaction of prices and a time-varying risk premium. Trend-following strategies simply try to identify those times when slow price behavior is present.

Similarly, the authors could have developed an alternative viewpoint against trend following. Noise trading, bubble creation, technical gimmickry, anti-fundamental behavior, speculative excesses, and market destabilization have all been attributed to trend following. Taken to excess, even a good strategy may reduce market welfare. Everyone cannot be a trend follower.

Trend following is actually too simple a term to describe the strategy used by participants in managed futures. For example, trends can come with multiple time frames and through a variety of identification mechanisms. They have different return distributions and are not correlated. The authors show that identifying oneself as a trend follower is open to wide interpretation and substantial variance in results.

Finding trends is a form of price-based signal filtering. Additionally, signal extraction is just a small part of what trend followers do. Position sizing and adjustment, risk management through stop-losses, entry and exit trade generation, and portfolio structure are all part of what the strategy entails. For example, no less important than trend identification are portfolio construction and the risk management knowledge of when to exit trades. The combination of all these features encompasses the systematic trading and disciplined investing associated with CTAs. The real skill may not be finding trends but bundling them into a system.

Greyserman and Kaminski thoroughly analyze performance dispersion and variation in style factors among trend followers. There can be large return differences among CTAs, but a significant portion of these differences can be explained by style factors that include a divergent trend index, market size, equity bias, and trading speed factors. The authors show how a diversified portfolio of different CTAs can gain exposure to the major style factors but still provide unique return features.

The book ends with a set of chapters on the value of adding managed futures to a broader investment portfolio. The diversification benefits to a traditional portfolio are significant, and adding CTAs to a mix of other hedge funds is valuable. The authors go further than just showing how a CTA index will add value. For example, the benefits of adding CTAs are diminished when the investor uses multistrategy managers or large managers that avoid the smaller, less liquid futures. Diversifying a CTA manager away from trend following will reduce the diversification benefit to a portfolio. The authors add a twist to the allocation question by looking at the timing of adding CTAs. They find, ironically, that buying on dips and buy and hold are more productive than trying to chase returns with trend followers.

A minor problem with this book is its level of detail, although it far outstrips many other books in this regard. The authors have to walk a fine line between readability and providing the appropriate level of support for their conclusions. For most readers, they have done an excellent job, but those looking for a deep study may desire more specificity on the construction of the tests and analysis. Regarding the question of how effective trend following will be through time and compared with other strategies, the devil is in the details.

Broadly speaking, Trend Following with Managed Futures shows that strategy and market diversification, the ability to go short, and the freedom to engage in active management all make a difference in generating return. Might there be a style other than trend following that can capitalize on these advantages? The answer is presumably yes, but the authors are able to show that what could be the simplest of all strategies, which does not have a foundation in valuation, can do a very credible job of adding value through active management.

The authors have raised the standard for discussion concerning trend following. The hedge fund industry should take note, and all strategies should be given the same level of attention and detailed review. For investors who are contemplating a trend-following managed futures investment, this book should be the first place to go in getting up to speed.

More book reviews are available on the CFA Institute website or in the Financial Analysts Journal.

All posts are the opinion of the author. As such, they should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute or the author’s employer.