Trend Following Back in Fashion? It Never Left Fashion

Article from Miles Johnson titled, “Trend-following’ algo funds back in fashion”:

They are the fashion victims of the hedge funds world: funds that make money by copying exactly what everyone else has been doing. But more recently “trend following” trading strategies were regarded by investors as distinctly passé.

For most of the past decade, computer driven hedge funds that profit from identifying patterns across hundreds of different markets managed to make money consistently. The investors who placed money with these “black box” funds were rarely able to understand fully how they worked, but were confident that they would generate returns for their portfolios.

The financial crisis, and quantitative easing, threw a spanner in the works. With global markets drowning in central bank liquidity the computer-driven programs used by trend-following hedge funds severely malfunctioned, with many losing money over recent years.

Now, tentatively, it appears that many of these funds have shaken their long losing streak. AHL Diversified, the flagship trend-following fund owned by Man Group and one of the oldest of its type, has risen by 18 per cent this year, breaking a dismal run – having lost money in each of the past three years.

Isam, a $600m fund led by former Man chief executive Stanley Fink, has meanwhile surged by almost 22 per cent to become one of the top five performing hedge funds in the world this year according to data compiled by HSBC.

“At the start of the year many people said momentum following was broken and can never work again,” says one senior hedge fund figure. “I found that extraordinary. It was like in the late 90s when people in equity markets would say value was dead. To assume trend following was permanently broken was excessively brave”.

Other funds may not be performing quite as strongly, but they have at least not been losing money. Cantab Capital Partners’ $2.5bn quantitative fund is up 2.4 per cent compared with a painful fall of 27.6 per cent in 2013. Winton, founded by David Harding, the “H” in AHL, is up 2.2 per cent, a decline on the sector-defying 9 per cent return it generated for 2013.

While their very nature makes it hard to decipher exactly why the algorithms behind these funds have started to fire again, one recurring explanation the quants that run them identify is an end to the high levels of correlation across many markets seen during QE.

Trend followers, which mostly trade in and out of liquid futures markets across most asset classes, were left particularly frazzled. The high correlation removed the ability of the algorithms driving these hedge funds to spot the same trends as they could before. To make matters worse markets tended to fall together just as they had earlier risen in tandem, meaning any gains were soon wiped out.

Central banks determination to stave off an economic depression following the banking crisis of 2008 with record low interest rates had the effect of causing many markets to rise at the same time.

“The more correlation we have the less markets we have,” says a manager at one trend-following fund. “Since 2008 we basically lost our diversification, and we have only just got that back.”

Some managers argue that a smaller size can help their funds trade more easily in and out of less liquid futures markets, such as milk futures, and make money where others cannot.

“We have definitely benefited from our ability to allocate meaningfully to wider sets of differentiating markets,” says Mr Fink of Isam. “The significant experience in our team helps us allocate to a number of markets that are often both capacity constrained and challenging to trade efficiently and we will continue to exploit this area of advantage.”

All agree that this year has been the first since the crisis without a large number of interventions by central bankers in markets, meaning some asset classes are showing signs of reverting back to trading on fundamental factors.

There have been more unexpectedly sharp movements across certain markets this year, such as soft commodities and currencies, which computer-driven strategies have been able to take advantage of.

Conventional market wisdom at the start of the year believed that bond yields could not fall any further, meaning trend followers that were correctly positioned have made money as human traders rebalanced their positions.

And for now, the computers are winning. “Their models seem to be picking up something the [human led] macro fund managers are not,” says Alper Ince, managing director at Paamco, a $9bn investor in hedge funds.

Has there ever been an accurate media piece on trend following?