Managed futures funds had a big revival after a «dead decade». The end of easy money has favored trends in rates, commodities and currencies. But the trend-following bubble might already have burst.
Who wins from the end of quantitative easing? Computer-driven hedge funds. Especially those following trends. As it would seem, the trend is your friend again: once overriden by central banks, trend followers are back after a dead decade in which many of them were closed. Now they boast double-digit returns year-to-date and inflows kept coming in since January.
While the S&P 500 lost 14% this year, those funds based on quantitative methods have gained 16% through May 20, according to Morningstar. Also called managed futures funds or Commodity Trading Advisors (CTA), they use mathematical models to predict market movements. Put very simply, they make money by taking long positions in markets that are rising and short positions in markets that are falling in price. They are naturally thriving in such volatile environments in which rates, commodities and currencies are back to their own momentum.
«Trends are back», says Jacques Lemoisson, who founded GATE Capital Management with a strategy called «quantomental» (a mix of quantitative and fundamental). The end of central bank hyper accomodation has allowed for assets to be differentiated again. «During QE periods, everyone was buying and frontrunning central banks», says the Geneva-based manager. «We knew the prices of assets, but we didn’t know the value of assets. Now spreads are back, and a failing company can no longer borrow at the same rate as a government».
«This environment is ideal for trend followers because high volatility is combined with clear trends (downwards) on the stock market and (upwards) on commodities, rates and the dollar», says Lionel Melka, head of research at Homa Capital in Paris. Typically, many funds have been betting both on a bear market in bonds and on a bull market in commodities. This ability to generate alpha during volatile times is dubbed «crisis alpha» by the industry.
Managed futures funds at Natixis are up 29% this year, and Pimco’s made 15%. The BlueTrend fund, managed by Leda Braga, is up 26% in 2022. BH-DG Systematic, a joint venture between David Gorton and hedge fund Brevan Howard, gained 32%. Aspect Capital, co-founded by Martin Lueck, gained 29% in its Diversified fund, according to the Financial Times.
As managed futures experienced inflows this year, a bubble has formed. Just like the hedge fund bubble of the mid 2000s, we are seeing funds of funds reemerge in this space, taking the shape of ETFs replicating baskets of managed futures strategies. A product that promises the diversification benefits of hedge funds with the daily liquidity of an ETF, all of which at low fees.
This might signal a market top already. Another clue signalling that we might already be past the market peak is a report by Versor Investments, indicating that the largest CTA hedge funds in the world are using trend signals that have lost some of their attractive characteristics over time. In particular, the combination of downside protection with high upside participation (called convexity) has become less effective since last year. The paper suggests that «While some have interpreted the positive performance of trend-following strategies in 2021 and 2022 as a revival of trend-following strategies, we caution that this performance likely was driven by material exposures to the least convex strategy components, which had exceptionally good performance in 2021 and 2022.»
Their conclusion is interesting because it suggests that they shouldn’t continue to just follow trends: «In order to continue generating attractive risk-adjusted returns in the future, such funds will need to construct their portfolios to combine trend-following signals with effective non-trend signals». In other words, more risk-taking is required to produce the same past performances. That is a good lesson about the way of alpha: it is an ever moving target. In that area, old recipes never apply eternally, crowded strategies stop being effective, and replicating those performances won’t take the same tricks.