Trend following has its merits

The majority of money managers strive to make the right call on the direction of the markets. Keith Balmer, a portfolio manager at U.K-based AHL says there is a case to be made in reacting to, rather than predicting, markets.

AHL manages more than $22 billion in managed futures assets. The AHL Diversified Programme, a managed futures hedge fund, has crushed the majority of traditional mutual fund mandates, with an annualized return of 17.6% since it’s inception in 1996 (although the fund was down 16.9% in the last year). In the wake of the financial crisis that occurred last year, world stock indices would have returned 3.2%.

The AHL DP has been launched as a stand alone investment product by Man Investments Canada — The Man Canada AHL DP Investment Fund. Balmer was in Toronto this week to promote the product as well as the broader concept of how successful trend following in managed futures can be in mitigating the overall risk of an investment portfolio.

Balmer says AHL doesn’t make a call on the markets. Instead, a team of more than 70 researchers, statisticians and investment analysts have built a quantitative model that tracks pricing data on managed futures and identifies steady trends in the futures markets.

The fund then simply adds to its position in the direction of the trend, making money on drawn out upward or downward trends. The nature of future contracts is such that the buyer of a future is long, the seller is short. You’re either on one side or the other.

“We’re effectively a systematic trader — a quantitative trader. We rely on analyzing market data and looking for patterns in historical data. We buy something, building a set of trading rules, test those trading rules and put that data into a systematic playbook — essentially putting them in a computer,” Balmer says. “We don’t make bets as to what’s going to happen in six months. What we’re doing is reactive and as the price moves in one direction, we’ll build into that position and profit as that trend continues.”

Balmer says while their methodology is quantitative, the trends are reliable in the market as long as the majority of investment decisions are made by humans.

“Humans tend to have two emotions: fear and greed. It’s a herd mentality that causes these trends. There is always going to be trends as long as humans are in the market,” he says.

The concept would suggest that the fund would have wild swings in risk and performance, since risk tends to greatly increase as asset price trends peak. Thus far, the fund has managed to have a volatility level in line with major stock indices.

“The risk that we’re taking is pretty much commensurate with the global stock market. In fact, our volatility is lower than the [S&P TSX/Composite Index]. For a Canadian investor who is happy to invest in Canadian stocks, you’re pretty much taking the same amount of risk,” Balmer says. “The worst drawdown we’ve had in the past 15 years is 17.9%. You compare that to world stocks, which lost 51%.”

Balmer says the key to managing losses is to target risk rather than performance, a concept that is growing in popularity especially with institutional managers, but has been practiced by AHL for more than a decade.

He says the AHL DP Fund will start to divest itself out of an asset class when risk — volatility — starts to overtake performance.

“We don’t know when a trend is going to reverse, and we don’t predict when a trend will reverse. We wait until it does. For example in 2008, when you saw the price of oil rising and analysts saying it’s not going to get above $100, then $110, $125 and so on, we were following it because the data said differently,” he says. “We just follow it as the price goes up, and we followed it until $143 and when the price reversed we followed it on the way down.

“When you have analysts arguing whether the price is going up and some are saying it’s going down, when you aggregate that together in one signal, you actually only get a small position. You have a low confidence in your ability to predict what direction that price is going to go.”

AHL will substantially reduce its position when there doesn’t seem to be a consensus price trend and returns are choppy. When a trend clearly reverses against them, they act quickly.

“When we’re on the wrong side of the trade, we react very quickly. Our positions come down very quickly. Which means that, yes we lose money, but we only lose a small amount of the profits we earned on the trend,” he says.

Balmer argued that the non-correlation of managed futures could be their biggest selling feature. The financial crisis saw seemingly non-correlated asset classes go in the same direction: down.

Compared to world stocks, AHL DP had a correlation of -0.21. Balmer says the fund was able to make some nice returns during the worst of the downturn. He argues, if allocated properly a managed futures product can nicely hedge traditional asset classes.

“A lot of people use managed futures as a type of insurance policy. The reason for this is because managed futures do very well in crisis periods,” he says. “In 2008, you have clear directionality across a range of sectors, everyone was selling stocks, everyone was buying bonds; everyone was buying gold and selling U.S. dollars. What do we make money on? Clear trends.”

(01/21/10)