Exploring the Trend in Trend Following: Q Group Presentation · 2020. 10. 18. · Trend Following...

STRICTLY CONFIDENTIAL. NOT FOR DISTRIBUTION.

Exploring the Trend in Trend Following: Q Group Presentation

David M. Modest, Ph. D.

October 19, 2020

STRICTLY CONFIDENTIAL. NOT FOR DISTRIBUTION. PREPARED FOR THE EXCLUSIVE USE OF THE INTENDED RECIPIENT.

Disclaimer

This presentation is for the Q Group Fall 2020 October 19, 2020 and is for information purposes only. The

information in this presentation is believed to be accurate as of the date set forth on the cover. Osprey Bay Capital is under no obligation to update this information. This presentation does not confer any rights on the recipients or impose any obligations on Osprey Bay Capital. This presentation is provided for discussion purposes only, is only a summary of certain information, is not complete, does not contain

certain material information and is subject to change without notice. No assurances can be given that

investment objectives will be achieved, and investment results may vary substantially on a quarterly or annual basis. As with any hedge, private equity, or venture fund, past performance cannot assure any

level of future results. Actual returns for each investor may be different due to timing of investments. This presentation is neither an offer nor a solicitation to buy an interest in any fund managed by Osprey Bay Capital, which can only be made pursuant to a confidential private placement memorandum and only in a

jurisdiction where permitted. The information contained herein is confidential and is intended solely for

conference participants. Delivery of this presentation to anyone other than the recipient or his designated representative is unauthorized, and any other use, reproduction, distribution or copying of this document

or the information contained herein, in whole or in part, without the prior written consent of Osprey Bay Capital is strictly prohibited.

PAGE 2


Background


Research Motivation

• Research grew out of twenty months as Chief Investment Officer of AlphaSimplex Group (ASG) LLC from December 2016 to August 2018

• ASG (a Natixis subsidiary) focuses on liquid alternative strategies (i.e. strategies with daily liquidity). The two primary strategies are:

- Managed Futures: multi-model, multi-horizon pure trend following strategy implemented using futures and forward contracts

- Global Alternatives: seeks to replicate the exposures of hedge funds to a diverse set of risk premia

• Currently working on four papers that grew out of my experience there

PAGE 4

Bertrand Russell: ``When you are studying any matter or considering any philosophy ask yourself only what are the facts and what is the truth that the facts bear out. Never let yourself be diverted either by what you wish to believe or by what you think would have beneficent social effects if it were

believed, but look only and surely at what are the facts.’’


Diminishing Returns for the Managed Futures Industry

Average Returns

SG Trend BTOP 50 Risk-Free

Start Date Jan 2000 Jan 1987

1980s 22.2% 6.5%

1990s 9.3% 4.8%

2000s 8.6% 6.6% 2.7%

2010s 2.0% 1.0% 0.5%

PAGE 5

Note: Average annual returns on the SG Trend and BTop50 indices computed from return data on BarclaysHedge website. The risk-free rate data is taken from Ken French’s website.

Average returns have decreased as assets-under-management (AUM) in Managed Futures strategies have risen from roughly $300MM in 1980 to ~$300BB today.

Direction of performance and fund flows consistent with Berk and Green (JPE 2004) …. although adjustment period appears lengthy


Difficult Investing Experience for Retail Investors

PAGE 6

Note: Estimated profits are derived from return and AUM data provided in the CRSP mutual fund database. Estimatedfees are derived from CRSP AUM data and fee disclosures reported on the SEC Edgar database. Profits and fees arecumulative estimates since inception based on end-of-month values through June 2020.

Experience for investors has been worse than the time-weighted average returns

CUMULATIVE PROFITS AND FEES SINCE INCEPTION

AlphaSimplex AQR

Managed Futures

Managed Futures

(MF)

MF High Volatility

AQR Total

Inception Date July 2010 Feb 2010 August 2013

Est $ Profit -$158.8 -$1,050.2 -$166.1 -$1,216.3

Est $ Mgmt Fees $220.4 $673.9 $43.9 $717.8

Est $ Total Fees $270.4 $830.9 $50.4 $881.3

Since the beginning of 2016, AQR’s retail investors have lost~$2.4BB in their Managed Futures products (regular and high-volatility)…. and ASG’s retail investors have lost ~$300MM in their retail products

Note: Cumulative profits from inception through June 2020.


Back to Basics


Back to Basics I

PAGE 8

What do we truly know and what are we assuming?

Explicit Assumptions Implicit Assumptions (examples)

• Buy what has gone up and sell/short what has gone done

• Expected utility is maximized by following a momentum strategy• Even if you think there is a 95%

chance that an asset which has gone down will rebound, you still want to be short

• Trend follower preferred an Italian 10-year bond trading at 80 basis points in Sept 2019 to the same bond trading at 183 basis points in August 2019

• Use multiple lookback windows to assess trend direction

• Optimal weighting of the windows is relatively unchanged over time• Barbell approach with most of the

weight <3 and >8 months

• Capital decisions are based on risk rather than notional allocations

• Benefits of increased diversification outweigh leverage risks associated with leveraged bond and other leveraged positions


Back to Basics II

PAGE 9

What do we truly know and what are we assuming … continued


• Historical volatility and correlations provide useful forward-looking estimates

• Negative gamma trading strategy is not too costly given the inverse relation between price & volatility

• Allocate risk equally between 4 major asset classes (equities, bonds, currencies and commodities) based on trend signals

• Equal risk weighting (a.k.a. risk parity) improves diversification (relative to notional weighting) and reduces tail risk• (c.f. Bridgewater All Weather

Strategy)

• Historically over the last 40 years, managed futures have been structurally long equities and long bonds• S&P500 index 111 on 1/1/80

and 3408 on 10/5/20


Back to Basics III

PAGE 10

What do we truly know and what are we assuming … continued


• Ten-year U.S. yields dropped from ~16% in the early ‘80s to ~8.5% at the beginning of the ‘90s to ~4% at the beginning of the new millennium to < 1% today

• Equal risk weight of long equities and long bonds has provided a natural hedge to equity crash risk

• Historically, you have been paid to receive this crash protection (given the upward sloping yield curve)

• ~$15 trillion of global debt has negative


Back to Basics IV

PAGE 11

What do we truly know and what are we assuming … continued … continuedExplicit Assumptions Implicit Assumptions (examples)

• Equal risk weighting has desirable mean-variance properties when the asset classes have roughly identical ex-ante Sharpe ratios (ceteris paribus)

• Allocate risk equally within asset classes to individual assets

• The diversification potential of investing in many different individual assets is not severely impinged by the integration of global markets

• There is sufficient liquidity at the individual asset level


Some Binomial Observations


$10

-$10

$20

$0

-$20

$30

$10

-$10

-$30

$40

$20

$0

-$20

-$40

Date 0 Date 1 Date 2 Date 3 Date 4

$0

Simple Binomial Framework

Hypothetical Profits to a Long-Only Investor

Assume constant notional investment of $100 over time

Binomial tree shows cumulative profits as of given date


Probability Distribution of Long-Only Profits

PAGE 14

Assume heads and tails are equally likely

0.00%

5.00%

10.00%

15.00%

20.00%

25.00%

30.00%

35.00%

40.00%

-40 -20 0 20 40


Trend Following Profits with a Fair Coin

PAGE 15

Profits associated with sixteen possible outcomes for long-

only and (fast) trend following strategies.

Path

Date

1

Date

2

Darte

3

Date

4

Long Only Profits

Fast Trend Profits

1 u u u u 40 402 u u u d 20 203 u u d u 20 04 u d u u 20 05 d u u u 20 06 u u d d 0 207 u d u d 0 -208 u d d u 0 09 d u u d 0 -2010 d u d u 0 -4011 d d u u 0 012 u d d d -20 2013 d u d d -20 -2014 d d u d -20 -2015 d d d u -20 016 d d d d -40 20

Table 1: Hypothetical Outcomes and Payoffs

Trend Outcomes Cumulative Profits

Consider a (fast) trend-following strategy where the trend follower starts long the market. If heads is tossed, the trend follower stays long, but if tails is tossed the trend follower goes short. This is a fast trend following strategy in that next period’s position only depends on the outcome of this period’s coin toss.

GREEN indicates positive outcome (profit) for the strategy and RED indicates negative outcome (loss).


Trend Following Generates Crisis Alpha

PAGE 16

By construction, if large losses over time are the result of repeated

negative events, trend following will provide crisis alpha.

-$20

-$10

$0

$10

$20

$30

$40

$50

$60

$70

$40 $20 $0 -$20 -$40

Figure 3: Average Trend Profit and Crisis AlphaConditional on Long-Only Profit

Trend Profit Crisis Alpha


Observation #1

PAGE 17

For both strategies, maximum profit = $40, maximum loss = -$40, expected

profit = $0 and the variance of profits = 400

Quant

Analysis

In this simplified binomial setting with no trend inasset prices, the trend-following strategy:

• Has the same expected profits and variance ofprofits as a long-only investment strategy.

• The dynamic nature of the trend-followingstrategy shapes the return distribution andsubstantially changes WHEN the profits andlosses occur


Observation #2

PAGE 18

Trend Following produces crisis alpha even in an efficient market (when

large losses are due to repeated negative outcomes).

Quant

Analysis

Although there is nothing “smart” about this simple trend-following strategy, it is able to generate “crisis alpha’’ and prevent losses in those states of the world when the long-only investor is most seriously affected—despite the absence of predictable trends in asset prices.


Long Call Option Profits

PAGE 19

Also well known that other dynamic strategies can change the timing of when you make and lose money

Quant

Analysis$10

-$10

$20

$0

-$20

$30

$10

-$10

-$30

$40

$20

$0

-$20

-$40Date 0 Date 1 Date 2 Date 3 Date 4

$0

$0

$10

$30

$0

Gross Option Payout

Net Option Payout

-$4.375

-$4.375

$5.625

$25.625

-$4.375

Figure 4: Cumulative Hypothetical Profits to Long-Only and Long Call Investors

$0

Consider a call option with an exercise price of $10


Long Call Option Profits

PAGE 20

Owning a call option also generates crisis alpha

Quant

Analysis

-$20

-$10

$0

$10

$20

$30

$40

$50

$60

$70

$40 $20 $0 -$20 -$40

Figure 5: Average Long-Call Profit and Crisis Alpha Conditional on Long-Only Profit

Long Call Net Payoff Crisis Alpha


Observation #3

PAGE 21

Owning a call option produces crisis alpha although no abnormal profit in an efficient market.

Quant

Analysis

Buying (and selling) options is an example of another dynamic investment strategy that can shape the conditional distribution of profits—i.e., when profits occur—even though the first two moments of the unconditional distribution are unaffected.


Trend Following Profits with an Unfair Coin

PAGE 22

Profits associated long-only, fast- and slow trend following strategies when

probability of an up market exceeds the probability of a down market.

Fast trend-following strategy depends only on last period’s outcome. Slow trend strategy depends on last 2 period’s outcomes.

GREEN indicates positive outcome (profit) for the strategy and RED indicates negative outcome (loss).

Path

Dat

e 1

Dat

e 2

Dar

te 3

Dat

e 4

Dat

e 1

Dat

e 2

Dar

te 3

Dat

e 4

Long Only

Profits

Fast

Trend

Profits

Slow

Trend

Profits

1 u u u u u u u u $30 $30 $202 u u u d u u u d $10 $10 $03 u u d u u u d u $10 -$10 $04 u d u u u d u u $10 -$10 $05 d u u u d u u u $30 $10 $106 u u d d u u d d -$10 $10 -$207 u d u d u d u d -$10 -$30 $08 u d d u u d d u -$10 -$10 -$109 d u u d d u u d $10 -$10 -$10

10 d u d u d u d u $10 -$30 $011 d d u u d d u u $10 $10 -$2012 u d d d u d d d -$30 $10 $1013 d u d d d u d d -$10 -$10 $014 d d u d d d u d -$10 -$10 $015 d d d u d d d u -$10 $10 $016 d d d d d d d d -$30 $30 $20

$0.00 $0.00 $0.00

$9.00 $2.70 $2.00Probability of Heads = 65%

Cumulative Profits Periods 2-4

Expected Profit

Table 3: Hypothetical Outcomes and Payoffs

Slow Trend Outcomes

Initial Position: Neutral

Fast Trend Outcomes

Initial Position: Neutral

Probability of Heads = 50%


Observation #4

PAGE 23

Trend Following can generate positive expected returns and deliver crisis alpha even in an efficient market.

Quant

Analysis

In general, trend-following strategies will earn positive profits—even in efficient markets—as long as asset prices have a consistently positive (or negative) trend. The dynamic positioning of the strategy enables it to earn positive profits during sustained and predictable market moves in EITHER direction --- as long as the moves play out over a sufficient period of time.


Looking Back at the Beginning of 2019

PAGE 24

Quant

Analysis

Why Algo Traders See Looming 'Chaos' in the Markets:Computer-driven funds are now short sellers of nearly every asset classBY MARK KOLAKOWSKI (Updated Jan 15, 2019)

‘’As computer-driven algorithmic trading becomes an increasingly more important factor in the market, the recent massive shift towards a bearish stance among a subset of these programs has worrying implications. “This is like the chaos bet,” according to Kathryn Kaminski, chief research strategist and co-manager of a managed futures portfolio at AlphaSimplex Group, as quoted by The Wall Street Journal.“Pretty much any way you run the models, you end up net short a lot of asset classes," Kaminski added, noting that this is the biggest swing from bullish to bearish among trend-following algorithms since 2007 and 2008 (see below). That, of course, was the era of the subprime meltdown, the financial crisis, and the most recent bear market for the S&P 500 Index (SPX).’’Source: The Wall Street Journal

KEY QUESTION:

Did ``Managed Futures Traders See a Looming Crisis’’? or

were ``They Positioned Short in Case There is a Crisis’’?

https://www.investopedia.com/contributors/54001/

https://www.investopedia.com/terms/a/algorithmictrading.asp

https://www.investopedia.com/terms/m/market-strategist.asp

https://www.investopedia.com/terms/m/managed-futures.asp

https://www.wsj.com/articles/computer-models-to-investors-short-everything-11547038800?emailToken=8696d9bd839a4080de05f03d5fe0117eCGZ9um0ecw9Vx5ATIK0AWGaGT8tGNwpKA7Ee8lW9afVJWQ+rxRLXxEJxBs+Eo33+qHM2RQXuPaeZnk000QA5yIft1tDKcZ057W/kGlY//pc%3D&reflink=article_email_share

https://www.investopedia.com/articles/02/051502.asp

https://www.investopedia.com/articles/07/subprime-blame.asp

https://www.investopedia.com/terms/f/financial-crisis.asp

https://www.investopedia.com/terms/s/sp500.asp


Modern Portfolio Theory Revisited

• Construction of the minimum variance portfolio does not require Expected Returns as an input. It only requires estimates of variances and covariances.

• It is the maximum “defensive” portfolio.

• Other portfolios on the efficient frontier trade-off “offense” and “defense”.

• Is Trend Following more “offensive” or “defensive” in spirit? (Defensive in not wanting to miss large moves in EITHER direction)

PAGE 25


Some Empirical Observations


A Toy Trend Following Model

PAGE 27

A toy trend following model can be used to shed light on the benefit / cost of trend following’s dynamic positioning

• Strategy implemented across ~50 different futures markets spanning four asset classes: commodities, equities, fixed income, and foreign exchange

• Data starting in ~1980

• No adjustment for transaction costs or management fees

• Five single-horizon trend following strategies with lookback horizons of 21, 63, 126, 189 and 252 days

• Long (short) assets where the cumulative price changes are positive (negative) over the lookback window

• Equal risk weight across asset classes and individual assets- All assets and asset classes normalized to 10% ex-ante volatility- Within commodities, equal risk weight across agricultural, energy and metals

• Multi-Horizon strategy equally weights the five single-horizon strategies


Active / Passive Decomposition of Returns

PAGE 28

Gradually allow the strategy to become more dynamic

• Static Risk Parity (SRP): Choose the mode of the position signs; keep variances and covariances fixed over the entire sample. Hence, position sizes static over time.

• Dynamic Risk Parity (DRP): Allow the sign of the positions to change over time but keep all normalizing constants (that normalize to keep constant individual asset, asset

class and portfolio volatilities constant) fixed over the entire sample

• Stochastic Individual Volatilities (SIV): Allow individual asset volatilities to vary over

time

• Stochastic Asset Class (SAC) Volatilities: Allow asset class volatilities to vary over

time (and hence individual asset correlations)

• Dynamic Trend Following (DTF): Allow all normalizing constants to vary


The Value of Active Management I

PAGE 29

Little evidence that dynamic positioning adds to profits

Excess Returns: All Asset Classes

Lookback Horizon SRP DRP SIV SAC DTF

21 days 15.0 8.7 9.6 7.9 8.6

63 days 14.9 11.7 12.4 10.1 10.6

126 days 14.1 11.5 12.4 9.1 9.2

189 days 14.2 13.5 14.7 11.2 11.8

252 days 13.6 15.5 16.7 12.6 13.0

Static Risk Parity

Dynamic Trend

Following

Po

siti

on

do

no

t ch

an

ge

over

the e

nti

re s

am

ple

peri

od

Cost of dynamic positioning almost 5% per year

Ability to Short


The Value of Active Management II

PAGE 30

… especially within equities ….

Excess Returns: Equities


21 days 4.1 0.2 0.4 0.5 0.6

63 days 4.0 1.2 1.8 1.2 1.3

126 days 3.9 2.6 3.2 1.8 1.6

189 days 3.8 3.3 4.1 2.5 2.6

252 days 3.7 3.1 3.9 2.5 2.6

Cost of dynamic positioning of equities over 2% per year

Static Risk Parity

Dynamic Trend

FollowingAbility to Short


The Value of Active Management III

PAGE 31

…. And Fixed Income

Excess Returns: Fixed Income


21 days 7.8 5.0 4.6 3.1 3.4

63 days 7.9 4.3 3.6 2.5 2.6

126 days 7.8 3.8 3.3 2.0 2.0

189 days 7.9 5.0 4.4 2.7 3.0

252 days 7.8 5.5 4.6 2.9 3.0

Fixed income contribution to overall is profits is enormous over this ~40 year period

Static Risk Parity

Dynamic Trend

Following

Cost of dynamic positioning of fixed income close to 6% per year!

Ability to Short


Concluding Remarks: Trend Following

• Trend following profits are not per se inconsistent with efficient markets.

• Trend following, through its dynamic positioning, affects when profits and losses occur.

• Trend following will (by construction) provide crisis alpha provided that deep losses are the result of repeated negative outcomes and not the result of a “crash”.

• The profitability of trend following is not robust to changes in the speed at which information is disseminated in the economy

• Trend following is a defensive-oriented strategy in that the active part of the strategy is more defensive-oriented (preventing losses in down markets) than offense oriented (generating additional profits).

• Trend following has greatly benefited from the roughly forty-year decline in interest rates and the diversification benefits that come from allocating risk capital rather than notional capital.

PAGE 32

THANK YOU!

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