The simplest hedge fund strategy | Trend following

0:00 One of my favorite hedge fund strategies, which I personally use, is really simple. Maybe a little too simple, but it works. Here's why. February 24th, 2022. 2 years after the Fed helicopter cash to households to save the country from absolute economic armageddon, Russian army enters Ukraine for a special operation. They just they they wanted to take over the whole country. A supply shock hits the market. One of the world's biggest exporters of energy is sanctioned left and right [music] in the middle of a secular transition away from fossil fuels. Investors get a bit nervous, stocks begin dropping. It's time to go [music] a bit risk off and buy treasuries. The problem? This.

0:43 Roughly 30% of the money in circulation had been printed in just over 2 years. With supply chains disrupted and lower labor participation rates, there was no two ways about it. There was too much money chasing too few goods. The net effect? Inflation, and lots of it. With bond yields near zero, even negative yielding in some countries, federal banks begin hiking. Bonds, too, then begin to fall in tandem with stocks. Gold is not budging, traditional diversification methods are just not working. Where could investors possibly go? And in the midst of this chaos, this one hedge fund strategy had one of its best years, maybe ever. This episode is sponsored by Alph Architect ETFs, but more on that later. Historically, hedge funds have been kind of a black box. All right, then. Keep your secrets.

1:32 Most of them are extremely complex, opaque, and expensive to invest in. Not to mention, most of them are simply inaccessible unless you're loaded. But what if there was one simple strategy that even you could trade? Even better yet, what if this strategy could also provide much-needed diversification, especially when stocks and bond investors needed the most? Welcome to the world of trend following. Trend following, also called managed futures or CTAs in the hedge fund space is a simple strategy that seeks to buy what is going up and sell what is going down.

2:06 That's it. That's literally the whole thing. What? Bro, what are you talking about, man? Historically trend following has kept some of the lowest correlations to both stocks and bonds out of any other hedge fund out there with some programs even achieving negative correlations to stocks. I eat this thing zigs while others zag. You're probably starting to see how everything starts piecing together. You own assets that are uncorrelated to each other and then build a more robust all-weather portfolio. So, for example, here you can see how trend following has performed since 2020. In [music] 2022, it went up while both stocks and bonds went down.

2:43 If you were to step back even further than that, you could find years where trend killed it when stocks dived. Think years like 2008 [music] and yes, 2020. But why has trend following worked so well? What is it about this strategy that makes it so robust to periods of stock market turmoil? I could sit here and try to decipher this for you, but that would be kind of boring. So, I have a better idea. I invited Kathryn Kaminski to explain how investors could potentially benefit from including alternative strategies like trend following [music] in their portfolios. Dr. Kaminski is the chief research strategist and portfolio manager at Alpha Simplex. She's also the co-author of Trend Following with Managed Futures, The Search for Crisis Alpha. She is a former senior lecturer at MIT, where she also earned her doctorate. One of the most authoritative and respected voices in the managed futures trend space. You know, trend following is one of the most simple and most interesting strategies out there.

3:44 It's really about following the themes in the marketplace as they evolve using a data-driven approach. And so, conceptually I love it because you can tell anybody, like, "Hey, trend following, you buy stuff that's going up, you sell stuff that's going down." But, of course, the devil is always in the details. To do trend following in the financial markets is really about having a systematic process, sticking to the process, and disentangling the emotion that you might feel, which there's a lot of it in finance, right?

4:16 From how you trade. Let's use silver as an example. Silver has been an incredible trend. And exposed, you can look at it and say, "Oh, I need to be in that trend." But, with a trend following strategy, what you do is you have an approach and you follow the rules, and you buy it as it goes up, and as it gets volatile, and as the trend reverts, you start to size in, taking profits, reducing some of the losses on the way down. For me, like, why I was so fascinated about trend following is I was originally an academic. And back in the day, academics definitely frowned upon strategies like trend following because they preached the gospel of efficient market theory. If trend is such a strategy we all know, how can it still work if markets are also pretty efficient, which they are. And what I found is that trend following as a strategy captures time-varying changes across asset classes over time, and it tends to work the best when things are difficult and perhaps less efficient.

5:17 So, when you have a crisis, or when you have massive macro change that is perhaps uncomfortable and hard to understand, that's when the strategy gets in those trends without having to second-guess, but really sort of following themes in global markets as they change over time. So, essentially, it's a unbiased approach to saying, "Whatever's happening, we're going to be part of it, and we're going to capture those moves, and have a diligent method to do so." >> By buying what's hot and selling what's not, Trend seeks to evolve with the markets. So, it's really evolutionary theory applied to financial markets.

5:56 And when I say applied, I don't mean as a metaphor or as an analogy, I mean literally it is part of evolutionary biology. That was Andrew Lo, founder of Alpha Simplex, professor and director of the MIT Laboratory for Financial Engineering, >> [music] >> and of course Dr. Kaminski's PhD adviser. He proposed the adaptive [music] markets hypothesis, an alternative school of thought to Fama's efficient market hypothesis. Like many of you, I began with the idea that markets are efficient, people behave in a rational manner, and from that literature, I was brought to the psychology literature that showed all sorts of experiments, behavioral economics, behavioral finance, that [music] demonstrated that people did not react in the ways that we would predict using expectation of uh utility functions and so on. That digression to behavioral finance and psychology naturally brought [music] me to the cognitive neurosciences. That of course brought me then to artificial intelligence and the theory of bounded rationality, which eventually brought me to evolutionary biology and ecology, and ultimately when you synthesize all these various different schools of thought, you get what I call for lack of a better term, the adaptive markets hypothesis. In the words of Dr.

7:10 Kaminski, according to the adaptive markets hypothesis, markets are seen as ecologies made up of species. The players of Wall Street compete for resources and when doing so, make the market more efficient. However, when competition is low or human heuristic decision-making causes inconsistencies or the financial environment itself changes where information can drip slowly and players are slow to react, trends can emerge. When things are stable, then stable investment policies make sense. But when things are highly dynamic, well, [music] then actually things don't stay the same and people adapt to those kinds of [music] changes. When you have a year like 2022, we had a massive geopolitical shock with the Ukraine crisis. We also had the first period in a long time with incredible hiking of rates. And that was an extreme and challenging environment from both a macro and emotional perspective for most traditional stock bond investors. That is where trend [music] thrives.

8:12 Since then, we've been on a great run. During the periods following that, monetary policy instead became much more contained and the world has actually done quite well and equities have done great. So, there was less to capture from a macro perspective in terms of big change and big stress. We started this video talking about one of the best years for trend following. But since then, trend has experienced a choppy ride with returns being flat at best.

8:39 And personally, I think that's not only acceptable, but maybe even a good thing. See, if trend following seeks to profit from this location in the markets, there's been very little of that over the past 3 years or so. Except for perhaps one tiny little event. My fellow Americans, this is liberation day. Waiting for a long time. We then had liberation day, which basically said, "Boom, things are changing." Unfortunately, that was a shock. But it's the change after that shock that [music] slowly comes into the markets that creates new trends. I mean, look at the dollar trend that we've seen right now. You've seen the metal trend, base and precious, equities and not just US equities outside of AI. You're also seeing, you know, Japan, Korea, Taiwan.

9:28 In the wake of change, you see these opportunities and then consolidation. And according to Kaminski and her Market Cycles and Managed Futures Drawdown paper, trend following tends to have its best returns [music] after its deeper drawdowns. There's also this known historical quirk about trend which seems to have its best returns during both the best and worst [music] times for equities. This is what is known as the CTA smile. Having said all of this, the big question still remains.

9:54 Should you invest [music] in this strategy? And if so, how should you go about doing so to get the most out of it at the portfolio level? That's our bit. But before that, I wanted to tell you about today's video sponsor, and that is us. Our lineup of ETFs seek to deliver high conviction, highly differentiated strategies for investors and advisors. If you'd like to know more about our offerings, head to funds.alphaarchitect.com. Back to the video. A convergent strategy experiences many small gains over time with the occasional extreme loss.

10:29 A divergent strategy experiences [music] many small losses with the occasional euphoric win. When building portfolios that include trend following, I think it's important to understand the statistical properties of >> [music] >> each asset class and strategy. In the case of equities, they tend to follow a convergent distribution, frequent small wins and occasional big losses. In the case of trend, it tends to have [music] a more divergent distribution, frequent small losses, occasional big wins. When you take divergent risk, on the other [music] hand, you profess your ignorance to the structure of the risk that you have impending for you. What's interesting to me and why I like trend following, it is one of the only strategies that's very, very different.

11:14 It does actually have low correlation over long time horizons with things like equities, and most investors have a core exposure to equities and bonds. And so, to me, every investor should be looking for that real diversification, and they should see it as a strategic allocation into something that likes when the world is difficult, something that likes change and disruption so that you have a little bit more balance in your portfolio as a whole. I myself have been in trend since over 20 years and I it goes through cycles just like equities and you need to stay long-term. So that's really the key component.

11:56 >> all trend can be a very difficult exposure to hold if you don't have the right expectations about it. But if you understand what you're investing in, you keep it simple and use it as a diversifier, I personally believe [music] it's one of the best things you could potentially own in your own portfolio. By [music] investing in something that seeks to profit from market dislocations or in other words, slow crashes, you could potentially add robustness to your portfolio and hopefully maybe even return if done in the right way.