The term ‘alternatives’ is used in many ways, and for many different asset classes, strategies and investments. So, it is unsurprising that some investors and advisers are unsure what alternatives are, their potential benefits, availability, and how to use them in portfolio construction.
ALTERNATIVE ASSETS V ALTERNATIVE STRATEGIES
Broadly speaking, alternatives come in two forms - alternative assets and alternative strategies.
Alternative assets include a range of assets outside of what we class as ‘traditional’ assets - stocks, bonds and cash. They include investments like private equity funds, hedge funds, managed futures, commodities, real estate funds and derivatives contracts.
Alternative strategies, on the other hand, are strategies in which the underlying traded instruments may be traditional equites, bonds and/or other assets, but which are different from the buy and hold or ‘long only’ strategies typically used to invest in equities, bonds and cash.
They aim to be absolute return strategies as they seek to create positive performance in all market conditions. They use specific strategies and techniques, often across a wide range of instruments, including short selling and/or leverage, aiming to produce returns which tend to be de-correlated from equity and bond benchmarks.
Alternative beta strategies are alternative strategies which aim to capture risk premia or beta in a systematic way. It is difficult to strictly define alternative beta strategies, but various important themes do emerge. They:
Alternative beta strategies tend to exhibit less volatility than equity markets generally, thus serving to dampen portfolio volatility overall. They tend to have lower drawdowns (peak-to-trough decline in the asset’s value during a specific time period), are liquid and transparent, and usually exhibit little or no correlation with traditional equity and bond benchmarks.
A PROVEN ALTERNATIVE BETA STRATEGY
Long-term trend-following is an alternative beta strategy which aims to go long markets which are rising in price, and short markets that are falling. It is a trading strategy which tries to capture gains by analysing, and profiting from, a stock’s momentum in a particular direction.
Trend-following strategies are based on certain trends existing in financial markets across multiple timeframes, geographies and asset classes, including bonds, stocks, rates, commodities and currencies.
These trends are created by powerful behavioural forces which influence price movements so that they do not always behave in line with Eugene Fama’s Efficient Market Hypothesis. Fama’s hypothesis states that share prices reflect all information available, and that as a result, consistent alpha generation is in fact impossible, because only by purchasing riskier assets or by possessing inside information can an investor expect to consistently outperform the market.
Behavioural economics, in contrast, applies psychological insights into human behaviour to economic decision making, arguing that investors aren’t as rational as the Efficient Market Hypothesis suggests, and instead suffer from behavioural flaws which mean they act in ways that can push prices above or below their fundamental value, resulting in a long series of pricing anomalies, or trends.
Trend-following is a strategy which seeks to benefit from the fact that Fama’s hypothesis does not always hold true, so that even if prices do revert to fundamental value over time, there are periods when they move up and down in line with other forces, and trends form.
Trend-following does not attempt to predict the movement of asset classes, but instead seeks to profit from the existence of the trends, regardless of whether they are moving up or down.
WHAT DO TREND-FOLLOWING PORTFOLIOS LOOK LIKE?
Not all trend-following portfolios are the same, but they typically invest across a very wide range of assets and financial contracts.
If we take alternative beta manager CFM’s ISTrends Trust program as an example, it seeks to capture trends across five asset classes – commodities, currencies, fixed income, short-term interest rates and equities – by trading on more than 100 financial contracts.
Within each of the five major asset classes, there are sub-assets. Within commodities, for example, CFM ISTrends program seeks to identify trends in the prices of base metals, precious metals, energy, softs, grains and meats. Within currencies, the fund analyses 10 different global currencies, and in equities, nine different countries’ equities are included.
HOW TREND-FOLLOWING WORKS IN PRACTICE
A typical trend is made up of three stages – the lag, the overreaction and the end of the trend. How and why this happens is explained in chart one.
Lag
Initially, the price of a stock will lag a shift in fundamental value, because there will be a period of time in which new market information is not fully reflected in the price. In the chart below, the fundamental value of the stock has risen, perhaps due to a positive earnings release.
The change in the value of the stock is immediate, but the market price initially lags. Behavioural economists have identified a number of reasons for this, including:
Market overreaction
After the initial lag, the price overreacts. This overreaction (when the price of the stock moves above its fundamental value) occurs due to a number of reasons, including:
End of the trend
At some point in the process described above, the price will extend too far beyond fundamental value, and as investors recognise this, prices revert to fundamental value and the trend is over.
CAPTURING THE TREND: A HOW-TO GUIDE
A trend-following strategy aims to buy the asset on the upward price move and therefore capitalise on the subsequent overreaction, while also shorting markets which have fallen, and are expected to continue to fall.
With the benefit of hindsight, recognising trends over history is relatively straightforward, however identifying these trends before they occur and capturing them while they last is of course much more difficult.
This is why the large majority of trend-following strategies are run by quantitative managers, which invest in a systematic way, using math models and computational power to analyse data and guide trading and investment decisions. Experienced managers combine machine learning with research by humans to create trend-following strategies with an economic rationale. These algorithms take years of trial and error to produce strong results and are constantly re-assessed and modified.
Experienced alternative beta managers can see through reams of data, remove market noise and interpret quantitative and qualitative data, analyse what computers produce, then refine strategies to ensure that returns are produced in line with expectations, and that diversification benefits are sound.
DIVERSIFICATION BENEFITS OF TREND-FOLLOWING AS AN ALTERNATIVE STRATEGY
Trends are volatile and should be viewed over a long-term horizon, over which trend-following has consistently exhibited the following characteristics:
Examining the worst historical periods of market crisis, table one shows trend-following has been generally positive and anti-correlated to the S&P 500.
SUMMARY
Diversification has been called the “only free lunch in finance”, however conventional ideas of diversification, adding bonds to a portfolio to diversify away from equity risk for example, is proving ineffective, as is the common practice of diversifying within an asset class by choosing different managers. When we look at the evidence, there is often little or no true diversification benefit of this latter practice as the managers are themselves highly correlated, as table two shows. Even if the specific equities they choose are different, they are still invested in the equity market as a whole, and will therefore be affected by market movements. The same goes for fixed interest, regardless of manager difference, all fixed interest portfolios are affected by market movements in fixed interest markets generally.
Alternative beta strategies, like trend-following, on the other hand, have been known to be often de-correlated from equity and bond benchmarks, and so adding these strategies to a portfolio means that returns tend to increase more quickly than risk, and the net result is better risk-adjusted returns.
Understanding why one crisis occurred is often of little value when it comes to predicting the next one, and that’s why there is no “right time to invest”. Instead, as the old adage goes - “time in the market is more important than timing the market”. By having an allocation to trend-following strategies over time, investors have a chance to effectively protect their portfolio for an inevitable market downturn.
This Toolbox was produced by the CFM ISTrends Trust
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