"FREE LUNCH" AND TREND-FOLLOWERS ARE BUYING
Investors should reclassify CTAs from sources of crisis alpha to sources of macro trend exposure and to methods of exploiting inflationary and deflationary factors. Return sources based on relative-value volatility perform more consistently in down markets and are orthogonal to equity and CTA returns and can therefore become a potent inclusion within the institutional portfolio.
In our paper, "Free Lunch" and Pearl is Buying, we laid out a compelling case why institutions and investors alike should include an implied volatility asset in their portfolios. The case is especially clear given the asset's natural, negative correlation to both equities and managed futures and near-zero correlation to other asset classes. The performance of relative-value volatility during down markets further drives home the argument to include that asset within a given portfolio.
Also, within the prior paper, we provided strong analytical evidence which refutes the idea that CTA and trend-following strategies provide downside protection in markets when the S&P 500 was negative. The data is clear and undeniable. CTAs do not represent crisis alpha. However, we believe CTAs provide a valuable source of returns that are not captured in economically sensitive assets such as credit, equity, or real estate markets.
Due, in part, that CTAs were one of the few sources of positive return in the Great Financial Crisis, institutions, investors, and many CTAs themselves claim the misnomer that they provide downside portfolio protection. However, over the years we have observed many down-market moments in which CTAs did not provide positive returns.
In this paper, we will make the case that CTAs should not be viewed as solutions to down markets. That notion is erroneous. Rather, trend-following CTAs are their own asset class, driven by their own systematic and macro factors, and can and do provide a valuable and differentiated return stream that is valuable to the institution and investor alike.
CTAs and "Free Lunch"
In our opinion, when viewed correctly, trend-following CTAs reveal an asset class that is powerful and needed in institutional portfolios. Equity, credit, and real-estate markets are pro-economic cycle. These markets move with and from growth in GDP, business, and leverage. They move with the macro winds that blow from fluctuations in supply and demand. They track the underlying fundamentals of the global structure itself.
The below charts show the moves in the US dollar, Gold, and Crude and the corresponding profits generated by CTAs as expressed by the SG CTA Index. As we can see, major trends in the US dollar during the 2000s decade reverberated through Gold and Oil markets. During the Great Financial Crisis, a shorter-term, but strong counter-move created opportunities as well. In 2014 and 2019, shorter-term but clear trends also emerged.
During these periods, we can observe positive returns within CTAs. On the whole, CTAs captured these trends very well. During periods of non-trending markets, the CTAs struggled to perform. The analysis is simple, yet clear. CTAs are designed to capture macro trends, full stop. They have not historically captured each and every down market in the S&P 500, especially when the key macro trends were not in motion.
Rather, leave the equity market hedging to the markets which offer natural negative correlation to such moves. Our paper "Effectiveness of Hedging Instruments" discusses in detail how various hedging instruments perform in equity down markets. CTAs do very well at capturing macro trends and should not necessarily provide positive returns during down periods in equity markets. If macro trends are concurrent with equity down markets, they may provide protection. Should macro trends remain dormant during equity down markets, they may not provide protection.
The below charts show the trends in US Dollar, Gold and Crude Oil and how those trends correspond to the positive return periods in the SG CTA Index. For illustrative ease, we have marked those trends using blue channel lines.
In this section, we will review how CTAs impact other asset classes, including the Relative-Value Volatility asset class under which the Pearl Hedged VIX Program would classify. The reader should therefore bear in mind the following points; i) no analysis below utilizing various industry indices should be misconstrued or make the reader believe the Pearl Hedged VIX Program would perform similarly in periods during which the Program has not operated, and ii) that past performance is not necessarily indicative of future results. Prior to sharing our analysis using industry indices, we first disclose to the reader our own track record compared to the multiple indices we use further below. Please note, the SG CTA Index nor the CBOE Relative Value Index are investable indices. For the full performance record of each index used and the Pearl Hedged VIX Program, please find them below in Appendix I.
Market observers have proclaimed the demise of CTAs multiple times over the last decade. Therefore, it may come as a shock to some to know that the SG CTA Index has slightly outperformed the S&P 500 since January 2000. The below chart is the picture of diversification. Please note, the SG CTA Index is not an investable index.
The efficient frontier portfolios are shown below. Remarkably, the optimal, corner portfolio suggests a 70% allocation to CTAs and only 30% to the S&P 500 for the period between Jan 2000 and Apr 2020.
Therefore, the debate should not be if CTAs should take a place within an institutional portfolio, but how much. Over the last 20 years, the answer should have been likely more than we thought. The rationale for a large mix of CTAs includes the idea that CTAs can and do track important macro factors that exist below the surface of the business cycle. Currency moves which prompt repricing in commodities, inflation, and deflation are all factors that are expressed in the markets and in the directional trading style of CTAs. CTAs do deliver a different, beneficial return stream.
The market dynamics which create the ebbs and flows within implied and realized volatility are different and orthogonal to the dynamics which govern CTAs. As implied volatility is an effective hedge to equity markets, implied volatility and equity markets have a natural negative correlation as well. Therefore, by combining equities, CTAs, and a strategy designed to exploit behavioral imbalances in implied volatility, an investor may achieve a portfolio which can expand with the business cycle, persevere through the inflationary and deflationary trends, and absorb the shocks which inevitably occur along the way. The below efficient frontier reveals the benefits of such a robust portfolio. Please note, given limitations in data, the below analysis is shown from January 2005 to April 2020 which matches the full length of the CBOE Eurekahedge Relative Value Volatility Index ("CBOE RV Volatility"). Like the SG CTA Index, please note the CBOE RV Volatility Index is not an investable index.
Just as is the case between CTAs and the S&P 500, in our opinion, it is not a question of if, but how much of a given portfolio should be given to each of the three asset classes. And just as is the case between CTAs and the S&P, also in our opinion, the answer is likely more should be given to the relative value, implied volatility asset class than we may cognitively think is prudent.
Pearl was launched in 2014 to serve the needs of a California-based family office. At the time, Pearl had a mandate to create a portfolio of managers that were uncorrelated to equity markets. We built the portfolio primarily using market-neutral quantitative equity strategies and short-term and long-term trend-followers. As investors may recall, the second-half of 2014 was a boon to the CTA space. The portfolio performed exceptionally well during that time period. Having lived through that period, we learned two important lessons about trend-followers:
1. Regardless of the trading horizon of the trend-followers, they exhibited very high correlation to each other even though their numerical correlations to each other were low. They all tended to perform positively at the same time, and negatively at the same time. Perhaps daily this was not the case, but over multiple days and weeks, we observed that their performance overlapped substantially.
2. Although the trend-followers claimed they were diversified because they traded multiple markets, we experienced that our exposures in the portfolio were caused by the same underlying macro themes. In the case of 2014, the US dollar made a very strong bullish move causing all other commodities-be they grains, energies, metals, or currencies-to be repriced in dollar terms. Therefore, the move in USD gave rise to corresponding moves in other sectors. The trend-following managers layered their exposures accordingly and we made very good returns on these overlapping macro trades.
We concluded that high correlation existed among trend-followers, regardless of trade horizon, because they traded the same underlying markets and relied on the same trends and momentum to generate their returns. We also concluded that although they traded a wide array of markets, the returns of CTAs were more sensitive to the large macro moves in global economies and their returns were generated from layered exposures on the same underlying moves. Effectively, the portfolio was a two-legged stool. From the market-neutral quantitative equity strategies, we captured single stock and sector (think Buffet), style and size (think Fama French), and momentum and other equity factor alphas (think AQR). From the CTAs, we captured the macro trends. The portfolio felt incomplete.
From our research in the CTA space, we had come across managers who had folded in the VIX Futures as one of the many markets they traded. We found the use of VIX Futures very interesting and began the process of researching its properties on our own. From that research sprang the rest of our story which we covered in our previous paper.
But the motivation behind our research in the VIX Futures was to find a market that behaved differently than CTAs, differently than equity alpha, and which could provide true negative correlation to both market types. Hence, Pearl created the Pearl Hedged VIX Program which corresponds to similar properties exhibited by the CBOE RV Volatility Index. To recall how that negative correlation naturally exists, we refer you to our paper: "Free Lunch" and Pearl is Buying.
With significant changes in equity markets one must contemplate the overall portfolio and how it can take advantage of new opportunities. Equities and CTAs work in tandem to extract the directional trends in the business and macro cycles. The relative value volatility asset class provides stability and support to both and lifts the portfolio to compound capital rather than to just let it merely recoup difficult losses. Relative value volatility is the third-leg on the stool Pearl sought for early in its history. Please connect with Pearl to discuss relative value volatility and the benefits it can bring to your portfolio.
Below are the performance tables for the S&P 500 Price Index, the SG CTA Index, and the CBOE Eurekahedge Relative Value Volatility Index. The SG CTA Index nor the CBOE RV Volatility Index are investable indices.