While the term “alpha” is widely used, in our experience, it’s not particularly well understood. Alpha, properly defined, is return in excess of what could have been expected given the risks assumed to generate the returns. Notice that this is not strictly outperformance relative to a benchmark, but rather, its relative performance given the level of risk taken.

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?

Those familiar with 361 Capital know that our managed futures strategies fall into a particular niche referred to as counter trend, which makes our return patterns quite distinct from more traditional trend following approaches. Nonetheless, as we work closely with many of our clients on issues relating to asset allocation and portfolio construction, we are often asked for insight on the managed futures category more broadly, more so of late because over the last few years – 2016 in particular – trend followers have struggled a bit.   

So with that in mind, we decided to dive into the trend following world and figure out what has been driving returns.

We can’t help it. Like the cat who can’t stop chasing the light from the flashlight, despite the fact that it can’t be caught, so must we comment on headlines like this, “Hennessee Group: Hedge Funds Underperform in June” even though we know it’s a futile exercise.

Meb Faber recently referenced this BNY Mellon publication regarding institutional investment in alternative assets. It certainly verified institutional investors may in fact be delusional (Meb put it a bit more colorfully) when it comes to return expectations. We thought the State Street report showing the average institutional investor’s expected return of 10.9% was a “bit” crazy.  However, the BNY Mellon report takes crazy to a whole new level; for 2015 67% of respondents expected returns of 12-18% or more with only 1% of those surveyed expecting a much more reasonable 6-8% for their hedge fund investments! Many institutional investors were certainly disappointed and based on the State Street publication’s reporting of the very short time horizon given to managers who underperform, they made portfolio changes that are likely to degrade future returns.