They can be a versatile addition to a portfolio, delivering higher Sortino ratios in rising markets and acting as a protective hedge during downtrends.
Non-price factors
Most CTA managers aim to deliver this by using price momentum factors to power their quantitative models, but this approach has a tendency to over and undershoot market turning points and miss return-generating opportunities. I strongly believe trend-following CTA strategies are enhanced by the inclusion of non-price factors.
Such factors, which include economic fundamentals, sentiment indicators, valuation data and fund flow information, can significantly increase the ability of models to predict future market direction. This allows for more accurate positioning and ultimately, enhanced returns.
But how?
For the answer, we must turn to the theories of economist John Maynard Keynes. When markets are volatile, Keynes observed investors tend to herd towards a consensus position. Only a significant event or announcement can prompt the brave few to take a risk and shift away from the herd. But over time, this outlier stance becomes less radical and some of the herd begin to break away from the pack.
As more steadily follow, market momentum is created until there is a radical positioning reversal and a new consensus is formed.
The inclusion of non-price factors can aid a model in gauging the direction of market movements and anticipating when shifts and reversals are likely to occur, giving it a forward-looking stance without introducing any of the biases or assumptions associated with human judgement.
With this information, one can attempt to position ahead of a trend in order to exploit momentum, but exit a position before the trend reverses, thus limiting downside.
News flow
To work effectively, the approach relies on the regular supply of macro news, indeed it thrives on the release of surprising announcements which deviate from consensus, shocking the market. The greater the flow of this type of information, the better the chance of getting the positioning right.
For example, back in June 2011, the eurozone crisis was in full swing and concern regarding the US debt ceiling was steadily mounting, resulting in investors being bombarded on a daily basis with dramatic headlines and worrying statistics. On inclusion of both price and non-price factors, models indicated economic growth was set to slow in the coming months, so we positioned long fixed income.
Through July, growth did slow, triggering a rally in bonds and short-rate futures – those reliant solely on fundamental data took longer to shift their positioning, limiting upside.
When conditions suit, this approach can work extremely well. However, predicting violent shifts and reversals in range-bound markets is definitely more challenging.
The inclusion of non-price factors in a CTA approach enhances the agility and flexibility of a strategy, allowing it to position ahead of the herd.
In the current climate, where neither equities nor bonds are delivering strong, consistent performance, these characteristics can prove extremely valuable, providing natural diversification when combined within a portfolio heavily geared towards traditional asset classes.
No-one can accurately predict when the eurozone crisis will be truly resolved and the global economy will start to show signs of strengthening growth and recovery. What investors need is a forward-looking strategy which takes advantage of these dislocated market conditions and employs volatility to its advantage – without giving up the potential to benefit once we do finally see a significant upswing in markets.
