Commodity trading advisors (CTAs) have long used trend-following strategies to capture directional opportunities in a broad array of markets, including equity, fixed income, currency, and commodity markets. Now, amid normalization of interest rates, in the wake of a post-pandemic inflationary shock and against a highly dynamic macro landscape, the concept of “unpredictability alpha” is a useful way to understand the ability of trend strategies to navigate uncertainty. This approach emphasizes the adaptive, agile and resilient nature of strategies that incorporate trend following to navigate an unpredictable macro environment in which global asset classes display divergence from one state of equilibrium to another, coupled with cross-sectional dispersion, further expanding the breadth of opportunities. In the current more fragmented, less synchronized global economy the continuing change in macro variables like inflation and interest rates as well as supply and demand factors are the breeding ground for trend formation which can then play out heterogeneously across regions and asset classes, hence divergence and dispersion.
Trend following strategies are designed to adapt to changing market conditions and exploit price movements in a risk-controlled manner, regardless of their underlying cause or direction. By being directionally agnostic and profitable in both rising and falling markets, trend following can help investors protect their portfolios from significant and persistent erosion of capital, as can happen during prolonged drawdowns for stocks and (more recently) bonds. The core principle of trend following is to systematically identify emergent themes in a wide range of markets and to capture persistent trends regardless of prevailing rhetoric or analyst forecasts. Trend following is therefore a naturally divergent strategy, a trading strategy that harvests change. This is a useful complement to the vast majority of investment strategies that are convergent by nature, driven by some measure of equilibrium, usually anchored on fundamentals. Trend following conceptually has a richer opportunity set when the macro landscape is dynamic and asset classes and geographies re-price from one stable equilibrium to some other. Not knowing, and in fact not needing to know where market prices diverge to is the essence of “unpredictability alpha”.
The return to normality and resulting dispersion and divergence
The post-pandemic era has seen a return to normal in many economic and performance indicators, with a notable increase in dispersion and divergence across both economies and asset classes. This normalization has included the re-emergence of inflation, the unwinding of quantitative easing (QE), and the advent of quantitative tightening (QT). These shifts have in turn led to more divergent prices in equity, bond, currency, and commodity markets. Central banks, particularly in Japan and Europe, have been adjusting their policies in response to these changes. Dispersion has returned as central banks have stepped away from close coordination and as a result, rate cycles are no longer moving in sync.
For example, in 2023 US GDP continued to outperform other economies. GDP in China slowed unexpectedly, and the nation cut interest rates, while the U.S. and many European economies steadily raised rates. Meanwhile, the Bank of Japan had maintained its ultra-low interest rate policy, which stood in contrast to other major central banks. This policy divergence remains, with the Bank of Japan recently ending its negative rate regime, by hiking rates and introducing quantitative tightening, whilst in Europe we have already seen rate cuts and the Fed is poised to cut rates as well, as signaled by Powell at Jackson Hole.
Macro divergence provides trend following strategies with a rich opportunity set given the reactive and directional nature of the strategy. In addition, by virtue of directional agnosticism – that is, trend strategies’ ability to generate returns from both long and short market exposures – trend following can display both defensive and growth characteristics in the broader context of asset allocation. By design, trend following strategies are structurally uncorrelated to equities, bond and commodities thus offering reliable diversification to traditional portfolios over the long term.
Commodities: You must be in it to win it
Commodity markets are often underrepresented in investors’ portfolios in favor of financial assets, but in fact they offer a very valuable source of diversifying returns, often unrelated to financial market drivers. Cocoa, for example, was largely dormant for over a decade before becoming a material source of return due to price increases in the wake of adverse weather conditions, crop disease, and supply constraints.
Cocoa prices have surged recently, highlighting the importance of maintaining a presence in idiosyncratic markets to capitalize on unpredictable price trends, with the most recent rally being among the most significant trends in this market’s history. This underscores the need to seek trends across as many different markets as possible and designing a strategy to be adaptive and agile enough to pounce on emergent opportunities however infrequent they may be. Trends are unpredictable but once they appear, they tend to be persistent. But you have to be in it to win it.
Financials: Winning strategies with the return to normality
The return to normality tied to the end of the QE era and the normalization of interest rates has seen a welcome return of dispersion and unpredictability in financial markets. This environment is ideal for trend-following strategies, which thrive in highly dynamic financial markets.
The recent performance of bonds has been a clear indication of the shifting landscape. The negative performance of the asset class in the face of rising interest rates has been a stark departure from the prolonged period of declining yields. Bonds were a poor diversification mechanism for equity investors in 2022 or in 2023, as the two asset classes returned to a positive correlation pattern. Trend following strategies are equipped to handle these shifts, as they are predicated not on mean reversion but rather on the adaptive exploitation of trends. The unbiased and unfitted approach could be well placed to profit from a breakdown of such relationships. Stocks and bonds have tended to be good diversifiers for one another, but – largely unpredictable at the time – the return of inflation in 2022 (after a multi-decade absence) saw both major asset classes declining at the same time. Trend following strategies, on the other hand, have demonstrated their “unpredictability alpha” credentials by reliably mitigating drawdowns in multi-asset portfolios, regardless of the mix of equities, bonds, or both that generated these losses.
Should trend strategies be deployed defensively or for growth?
Trend following strategies are sound in both defensive and growth portfolios. On the defensive side, trend strategies can provide valuable risk mitigation during periods of persistent erosion of capital. On the growth side, they can offer diversification and potentially enhance returns when traditional financial assets are performing well.
In a defensive scenario, trend following strategies can act as a hedge against market downturns. By being directionally agnostic and able to profit from both rising and falling markets, these strategies can help in the current environment, where the risk of market declines is ever present.
On the growth side, trend following strategies can contribute to portfolio performance by capturing trends in various asset classes. When traditional assets are in an uptrend, these strategies can amplify returns, providing an additional layer of growth potential and possibly maintaining a growth direction should there be a sudden correction elsewhere in the portfolio.
The dual role of trend strategies
Trend following strategies play a dual role in efficient investment portfolios, as they can act as both a defensive and growth position. This dual profile is being reconsidered by leading institutions through a total portfolio approach. The key is to tie the consideration of trend strategies to the overall goal of the portfolio, ensuring that they align with the investor’s risk tolerance and investment objectives.
By integrating trend following strategies into a total portfolio approach, investors can achieve a balanced and resilient portfolio that is capable of navigating the complexities of the current macro environment. By capturing “unpredictability alpha” investors can position themselves to benefit from the changing dynamics of the market, whether it be in commodities or financials.
As institutions continue to reevaluate the role of trend strategies within their portfolios, it is clear that these approaches are well-suited to the challenges and opportunities of the current economic climate. The adaptability, agility, and resilience of trend following strategies make them a powerful tool for investors seeking to thrive amid divergence and dispersion of returns and performance.
Note: Any opinions expressed are subject to change and should not be interpreted as investment advice or a recommendation.