"The Curse Of Convexity": How Central Banks Crushed Trend-Followers

In the aftermath of the February VIXplosion, which famously crushed countless vol-sellers and effectively eliminated the inverse VIX ETF asset class, another casualty emerged which was largely unreported: managed futures or Commodity Trading Advisors (CTA), also known as "trend-followers", which had just suffered their worst month on record.

Looking at their abysmal performance and inability to adapt to rapidly changing market shifts, JPMorgan warned that an "extinction level event" for trend-following strategies was coming.

And while that dire prediction has not materialized just yet, it is safe to say that with the February volatility bout, global markets ushered in a new regime of high volatility coupled with a lack of enduring directional trends, a market that in virtually every way was the polar opposite of 2017's record low volatility and smooth, gentle upward slope.

What happened? As SocGen explains in a Wednesday note looking at the "curse of convexity and trend-following strategies", the markets are now being pulled by the promises of late stage economic growth boosted by fiscal and to a lesser extent monetary stimulus. They are also contending against the risks of rising geopolitical tensions and the likelihood of potential recession. So they end up moving up and down with no clear direction.

Clearly, without clear, exploitable trends, such sideways markets are challenging for convex strategies such as trend following systems.  In fact, according to the SocGen CTA index, the performance of the asset class is now at the worst level since the end of 2014.

As SocGen adds, "with their convex profile, trend-following systems offer strong positive returns in long lasting bear markets while participating positively to the upside in extremely bullish regimes (see graph on the left).

In addition to underperforming in a directionless environment, trend-following systems may also fail if markets fall or rise abruptly. February this year is a case in point.

Furthermore, when looking at the past five years, SocGen notes that while the performance of the trend following industry has been weaker on average than its performance over the past century, beneath this there have been many different experiences, with much dispersion across assets. To wit:

In 2014-15, trend systems in fixed income and commodities benefited greatly from the US dollar rally, while equities were mostly range bound. In 2016-17, we saw the exact opposite: equities had a long period of positive performance in a very low-volatility environment, while rates, FX and commodities prices lacked direction.

The next logical question is why are trends disappearing in some markets and not others. According to SocGen, while the answer can be debated at length, one thing is certain: "as long as central banks are pulling the strings, the formation of trends will be challenged."

Over the years of quantitative easing in the US, buying shares at the bottom was retrospectively a winning strategy. More recently, central bank communication strategies and overwhelming monetary and fiscal stimuli are undercutting momentum in major asset classes.

Indeed, it may comes as a surprise to some, but whereas for much of the past decade, central banks did everything they could to make investors of all varieties rich, at least this year, maintaining the trend is not the central banker's friend. There is a silver lining: according to SocGen, "patience is a virtue"...

... and those who positioned for harvesting trends have typically been rewarded in the past. Over the past fortnight, trend followers are slightly down at -0.4%, with trends in fx and rates relatively strong (up 1.1% and 1.6% respectively).

Perhaps, but on the other hand 2018 has already seen an outlier year, there have already been a near record number of 1% reversals for the first half of the year, and as Bloomberg recently calculated, 2018 is already poised to be the most volatile year outside of bear markets.

Unless of course 2018 will not be "outside" of a bear market, and what is coming will be painful for all investors, not just CTAs.


BankSurfyMan Wed, 06/27/2018 - 16:39 Permalink

Those days of beepers and big honking sattelite car phones. Sharks were monsters of the seas and folks believed the police? GONE! Your chart has no weight, ALGORYTHIM is Market Bling and Death! There is no market, there is only you, the FOOLS of 2018! Crash and Burn America! Sorry ~ about that!

jm Wed, 06/27/2018 - 17:45 Permalink

This is an excellent post. 

My take is that trend strategies dominate mean reversion strategies (at some scale and instrument) almost all the time.  

Trend following underperformance is consistent with a slow unfolding process of trend reversal for which funds are/were not positioned correctly.  They can't be because the trend isn't established... the current market environment is too noisy to see a trend.  Seriously, here is where Taleb's "never sell an option" makes some sense, if it ever does.

Dispersion of trend performance across asset classes is due to idiosyncratic factors... equities have been supported by huge buy-back schemes, offsetting tight liquidity in all assets, low-latency creating an illusion of true liquidity in derivatives, etc. 

Trend following underperformance may be a good market indicator for when to derisk or position for an opposite trend.