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The Great Momentum Crash

All good things might not come to an end, but they certainly attract attention and ultimately create the potential for excess, as witnessed in the stock-market crash of the past few weeks. Nowhere in the investment world has this been more visible than in the quantitative investment strategy known as trend following.

In its simplest form, trend following is a strategy that buys high and sells low. Trend followers usually do so by using futures and swaps to create levered exposures across all asset classes, going both long and short. Asset classes might include equity index futures, currency futures, bond and interest-rate futures, commodity futures, and even futures on the Cboe Volatility Index, or VIX. By its nature, trend following is the opposite of mean-reversion, in which money is made by buying low and selling high. Trend following is similar to momentum strategies popular in equities, wherein an investor would buy past winners and short past losers. But trend following, also known as “time-series momentum,” is more general.

Volumes of research have been written on trend following, and many studies go back almost 500 years. The three promises of trend following quoted from back-tests are: Trend following delivers returns that are almost as good as buy-and-hold equities, but with better drawdown, or loss characteristics; trend following back-tests demonstrate that the strategy has been a diversifier against equity risk; and, trend following historically behaves like a long option position but without the options, in that it provides exposure to an increase in realized volatility without paying option premiums.

These three attractive features have enticed some investors to allocate a good percentage of their assets to CTAs (commodity trading advisers, another term for trend followers). Many years ago this strategy was brought to the mutual-fund world in an effort to draw investment from retail investors. Now, with the ease of trading futures that many such funds are allowed to use, this product has become “retailized,” just as volatility selling was retailized through inverse-volatility ETFs, which imploded spectacularly in the past two weeks. Care and prudence are warranted.

It is too bad that trend following by itself failed to deliver on any of the three promises in the most recent market selloff. As the markets rallied in January, trend followers did extremely well (showing positive correlation to equities), and might even have amplified the exponential growth of equities before the 10% correction. Then, as markets reversed, pure trend followers lost money (giving up all their gains and more from January), and might even have been part of the selling that exacerbated the reversal. Trend following behaved not like a long option position, but a short option position. As volatility spiked, trend followers, among others, might have de-risked, adding fuel to the fire, just as a short option would react.

As the equity markets have recovered, so have trend followers’ returns, confirming that they are indeed significantly positively correlated to equities, at least for short-lived corrections.

Why is this happening? This isn’t the first time that the collective act of diversification by many participants, all at the same time, creates a situation where the diversifying strategy actually becomes less diversifying. This happened many years ago when commodities became popular as diversifiers against equities and bonds. Due to the “financialization” of commodity exposures, they became more correlated with equities and bonds. During the financial crisis, investors flocked to asset-backed securities that were touted as a new, diversifying asset class with little correlation to equities, but asset-backed securities lost a lot of their value as the equity markets tanked. This happened not only because the underlying credit risk of the asset-backed issuers was called into question as equity markets weakened, but also because, when a large number of portfolios de-risk at the same time, they tend to reduce the equity exposure and the exposure to the so-called diversifier simultaneously.

The main lesson to be learned: When something looks too good to be true, it attracts copycats. Combine that with the ease of implementation and it leads to a massive crowding effect; the good thing is taken to its logical extreme by creative financial engineering. If the strategy is based on rules that are relatively easy to decipher, the good thing can become a dangerous thing, both because actions are anticipated, and also because the rules force action. For now, much of the plain-vanilla trend-following strategy is at that juncture, and will challenge investors’ belief in its ability to diversify equity risk over longer horizons. It is too early to tell, but will retail trend-following mutual funds be the next shoe to drop after the collapse of inverse-vol funds?

VINEER BHANSALI is founder and chief investment officer of LongTail Alpha, an investment firm based in Newport Beach, Calif. Any views expressed by Dr. Bhansali are solely those of Dr. Bhansali and do not necessarily reflect the views of LongTail Alpha, LLC, its affiliates or other associated persons.
This note was first published on Barrons.com on February 16, 2018.

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