Our blog post from last week, “Deconstructing Managed Futures Returns”, discussed the drivers of recent negative performance of diversified trend-following strategies, while showing their long-term effectiveness as a tool to both dampen portfolio risk and generate attractive returns. The downside of strategies that produce strong long-term performance, but deviate from equity markets, is that many investors find it hard to maintain discipline in the face of drawdowns, especially when they occur as stocks move ever higher.
The problem is universal for any strategy or asset class that is designed to have low or negative correlation to equity markets; they tend to behave differently from equity markets, which means they will often lose money or make very little during times of strong equity performance. Humans’ bias towards action leads to the much discussed “investor behavior gap” or the tendency of investors to sell an underperforming strategy and replace it with a better performing strategy at precisely the wrong time.
Is there a solution to this problem? Bluntly, the answer is no. Low correlation will always be difficult for investors to deal with during rising equity markets. However, we feel that one way to mitigate the impact is to diversify further, utilizing non-trend following strategies that also have a positive expected return and low correlation to equities. While somewhat self-serving, we have found short-term counter-trend strategies to be especially effective when paired with more traditional trend-following allocations.
Above is a comparison of a basket of short-term counter-trend strategies (STCT)1, the SG Trend Index and a 50/50 blend of the strategies together. The impact of adding a basket of STCT strategies to the trend following index is substantial. Volatility is drastically reduced, returns increase modestly and, most importantly, the drawdown is nearly cut in half.
In addition to the already-mentioned risk improvements, an investor maintains low to negative correlations relative to both domestic and global equity markets when including STCT strategies in their managed futures allocations. This seems like a win-win situation and is a practical way to weather difficult periods more effectively, allowing investors more time to hold low correlation strategies, and when the inevitable change in volatility and market direction occurs, the investor will be well positioned to benefit from the low to negative correlation provided from their managed futures allocation.
Read last week’s blog, Deconstructing Managed Futures Returns