An Honest Update On The Trend Following Landscape by Red Rock Capital
Trend following is the most prevalent strategy utilized throughout the managed futures industry. Over 27 months ago, during the toughest recession our industry had ever experienced, we published the original version of this paper. Our aim was to offer a transparent and intellectually honest update on the track records of many of the most well-known trend followers. At that time, all twenty managers included in our analysis, including our Systematic Global Macro (systematic trend following) program, along with all of the major CTA indexes, were in a drawdown off their all-time high water marks.
In late 2013, as Central Bank policies began to diverge, “beneficial” volatility (i.e. directional and sustained) began to manifest itself in many of the futures markets that are the core of most trend following CTAs’ portfolios. Most trend followers were able to capitalize on these favorable market conditions throughout 2014, with the best-performing managers producing all-time net-new equity highs, and in many cases, and then some.
2015 proved to be a more challenging environment as the Newedge CTA and Newedge Trend CTA indexes were only up 0.08% and 0.13%, respectively, for the entire year (Note: Societe Generale has renamed these indexes the SG CTA Index and the SG Trend Index, respectively).
While 2016 is already off to a productive and noteworthy start for most trend followers, the question remains the same as we posed in the original version of our paper: what is the best way to objectively analyze, measure, and compare the performance of a group of trend following CTAs?
To help answer this question we developed our own metric that measures and compares the “goodness” of similar managers’ returns. This paper updates our original work (and subsequent versions that were published during 2014 and 2015) and the measurements and ranking methodology that we initially introduced remain the same.
Who was analyzed?
This updated version of our paper includes analysis on 19 of the 20 trend following managers that we initially studied (one closed down), plus the SG CTA Index, the SG Trend (CTA) Index, the Newedge Trend Indicator (now called the ‘SG Trend Indicator’), and four additional managers that we added during 2014 – 2015. It is important to note that the SG CTA Index represents the equal-weighted performance of the top 20 largest diversified CTAs open for investment, the SG Trend CTA Index represents the equal-weighted performance of the top 10 largest trend following CTAs open for investment, and the SG Trend Indicator is a fully-disclosed, rule-based trend following strategy that offers an interesting and transparent look into the daily performance and positions of a professionally developed, albeit basic, trend model.
Trend Following – Common Misunderstandings
Each year it seems a manager or two in our list receives accolades for their ‘impressive’, outsized performance. For instance, during 2014 one manager made +67.38% and another produced +61.95%. However, the problem is reporting only these types of “return” numbers tells, at best, only half of the story (this is a fact; not just our opinion). When you hear a manager’s performance being quoted, the first question someone should ask is, “At what level of risk / margin-to-equity / volatility?” A Commodity Trading Advisor makes a subjective choice as to what level margin-to-equity to operate his or her program – but the level chosen is not, in and of itself, a source of “goodness.” Furthermore, an investor who opens a managed account with a CTA, through the use of notional funding, can modify the manager’s regular program volatility to suit their own appetite for risk. Therefore, due to the inherent leverage (i.e. free; no cost to lever up – unlike stocks) found in the futures markets, risk-adjusted returns (not absolute returns) are the only accurate and proper way to compare similar managers’ returns.
This point is repeatedly misunderstood by many in the managed futures industry. A program run with a higher margin- to-equity ratio will produce a higher compound rate of growth at the price of higher drawdowns (periods of loss). For example, assume one manager produces a +60% net return over 12 months and another manager only produces a +20% net return. If the second manager used only 1/3 as much margin-to-equity, and produced only 1/3 as much volatility in his returns, then the two managers’ performance were essentially equal on a risk-adjusted basis. However, the first manager will often win awards and be touted for having “better” performance – which demonstrates a lack of understanding of, or at least a lack of concern for, a crucial aspect about managed futures and how to correctly measure performance.
To bring this point full-circle, while the net returns of the two aforementioned managers of +67.38% and +61.95% during 2014 indeed sounded impressive on the surface, a study of their track records showed that the former had lost over 35% in one recent calendar year (and lists a 45.04% maximum historical drawdown) and the latter lost money in three consecutive recent calendar years and lists a 34.79% maximum drawdown. Both managers recently made all-time net-new equity highs, for which they should be commended, however, in order to get an intellectually honest and accurate reading of their true performance, one must include data on both returns and risk in one’s analysis.
Our proprietary metric aims to step into the shoes of a loyal, long-term investor with any of the managers that we analyze, and asks, “What aspects of my CTA manager’s performance are most important to me?” The following table conveys the most important aspects, the proxies we use to measure them, and the weight we give to each individual measurement in our weighted final ranking:
For the period since the inception of our Systematic Global Macro program (September 2003) through December 2015, we measure each aspect of the managers’ returns via our proxies and then assign them a weight similar to how one calculates a grade point average.
Once we have the rankings for each of the managers on the individual aspects, we combine the rankings at their respective weights to arrive at a final rank. This is a straightforward, quick method to compare similar futures managers to one another. By design, and to reduce the complexity of the process, the rankings do not have proportional information embedded in them, i.e. how much better is Manager A than Manager B, etc. When considering the results of our ranking presented in the table on the next page, the following should be noted:
- Since a CTA’s returns, volatility, and drawdowns are functions of a subjective decision that has been made by the manager, only analyzing the managers’ length and depth of their current (if applicable) drawdown is not sufficient. A risk-adjusted metric (referred to as “Reward to Risk Ratio” in the forthcoming table) must be applied that normalizes managers’ returns against one another.
- As we convey in our white paper, Sortino: A ‘Sharper’ Ratio, the Sortino ratio is a more appropriate measure to use for this purpose than the more popular Sharpe ratio. This is because the Sharpe ratio, by assuming that the returns it is measuring are normally distributed, unfairly and incorrectly penalizes managers whose returns exhibit positive asymmetry (skewness). In reality, investors typically welcome upside volatility and perceive only downside volatility as actual risk.
Observations & comments about the results:
- International Standard Asset Management (ISAM) now holds the #1 ranking. They finished 2015 at a net-new equity high, so both their ‘months in’ and ‘depth of’ current drawdown numbers in the above table are zero.
- Strangely there is still over $5 billion invested with managers in the bottom quartile of the final ranking. Despite significantly improved trend following conditions, some of those managers have not produced a net new equity high in over 6 years.
- The SG Trend Indicator, a fully-disclosed and freely-available-to-the-public strategy, has, according to our ranking methodology, outperformed two popular CTA trend following managers with hundreds of millions of dollars under management. As a caveat, though, the Trend Indicator was launched in August 2010 so only its performance since, and not before that time, can be considered out of sample.
- Interestingly, we discovered that a significant amount of performance data for one manager, at least in the database where we obtained our data – and sometime after our September 2014 version of this paper but before our May 2015 version – had been modified in their favor (effectively making their last high water mark easier to reach). Two full years of performance data changed after more than two years had passed? Surprised to learn this? So were we. Hopefully all of this was well-documented and on the up and up.
- A well-respected Introducing Broker recently suggested to us that an additional, pertinent characteristic to consider is the minimum managed account (SMA) size requirement for the managers and programs analyzed in this paper. Some minimums are reported to be $50 million – while qualified investors can obtain an SMA with some of the other managers on the list for only $500k.
- Good “recent performance”, as so many seem to focus on and reward with praise, needs to be kept in the correct perspective. For instance a manager could be up 10% one year and then up another 5% the following year (and win awards, etc.) then down -11%, and back up 8%… yet the entire time still be under their high water mark. Should a savvy, loyal investor, who has not experienced a net new equity high in 70+ months, really care if a manager is “up” this year to date? We argue that they should not.
Considering the length of some of the managers’ drawdowns, we believe concern is warranted, from a current or prospective investor standpoint, as to whether or not such managers will ever make another new equity high again. Unfortunately, as we’ve seen too many times before in our industry, those managers often share the same concern – and conveniently try to shift focus away from that particular program – only to launch another “new and improved” variant. Prospective investors would do themselves a favor by being skeptical of firms launching new programs, Mutual Funds, and ETFs in the wake of ailing flagship trend following CTA programs.
In this article we present an efficient and straightforward method to objectively measure and compare the performance of similar trend following CTA managers. Since late 2013, many of the managers in our analysis, along with the major CTA indexes, have produced impressive risk-adjusted returns. With all that is happening globally (e.g. recent ‘liftoff’ from ZIRP, Draghi’s ECB posture, U.S. stocks off to a poor start in 2016, etc.) it will be interesting to see what kind of market environment trend followers will have to work with in the coming months and years.
– Thomas N. Rollinger, Managing Partner
– Scott T. Hoffman, Partner