Tail Protection of Trend-Following Strategies

A related paper has been added to:

#118 – Time Series Momentum Effect

Authors: Dao, Nguyen, Deremble, Lemperiere, Bouchaud, Potters

Title: Tail Protection for Long Investors: Trend Convexity at Work

Link: https://papers.ssrn.com/sol3/papers.cfm?abstract_id=2777657


The performance of trend following strategies can be ascribed to the difference between long-term and short-term realized variance. We revisit this general result and show that it holds for various definitions of trend strategies. This explains the positive convexity of the aggregate performance of Commodity Trading Advisors (CTAs) which — when adequately measured — turns out to be much stronger than anticipated. We also highlight interesting connections with so-called Risk Parity portfolios. Finally, we propose a new portfolio of strangle options that provides a pure exposure to the long-term variance of the underlying, offering yet another viewpoint on the link between trend and volatility.

Notable quotations from the academic research paper:

"In this paper we have shown that single-asset trend strategies have built-in convexity provided its returns are aggregated over the right time-scale, i.e., that of the trend filter. In fact, the performance of trend-following can be viewed as swap between long-term realized variance (typicaly the timescale of the trending filter) and a short-term realized variance (the rebalancing of our portfolio). This feature is a generic property and holds for various filters and saturation levels. While trendfollowing strategies provide hedge against large moves unfolding over the long time scale, it is wrong to expect a 6 to 9 months trending system rebalanced every week to hedge against a market crash that lasts a few days.

We dissected the performance of the SG CTA Index in terms of a simple replication index, using and un-saturated trend on equi-weighted pool of liquid assets. Assuming realistic fees, and fitting only the time-scale of the filter (found to be of the order of 6 months) we reached a very strong correlation (above 80%) with the SG Index, and furthermore fully captured the average drift (i.e. our replication has the same Sharpe ratio as the whole of the CTA industry). However, our analysis makes clear that CTAs do not provide the same hedge single-asset trends provide: some of the convexity is lost because of diversification. We however have found that CTAs do offer an interesting hedge to Risk-Parity portfolios. This property is quite interesting, and we feel it makes the trend a valid addition in the book of any manager holding Risk Parity products (or simply a diversified long position in both equities and bonds).

Finally, we turned our attention to the much discussed link between trend-following and long-volatility strategies. We found that a simple trend model has exactly the same exposure to the long-term variance as a portfolio of naked strangles. The difference is the fact that the entry price of the latter is fixed by the implied volatility, while the cost of trend is the realized short-term variance. The pay-off of our strangle portfolio is model-independent and coincides with that of a traditional variance swap – except that the latter requires Back-Scholes assumptions. In other words, the option strategy is a better hedge and therefore its price should be higher than realized volatility.  The premium paid on option markets is however oo high in the sense that long-vol portfolios have consistently lost money over the past 2 decades, while trend following strategies have actually posted positive performance. So, even if options provide a better hedge, trend following is a much cheaper way to hedge long-only exposure.

All-in-all, our results prove that trending systems offer cheap protection to long-term large moves of the market. This coupled with the high statistical significance of this market anomaly, really sets trend-following apart in the world of investments strategies. A potential issue might be the global capacity of this strategy, but recent performance seems to be quite in line with long-term returns, so there is at presence little evidence of over-crowding."

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