Around the globe, institutional investors are concerned with the potential for rising rates and possible consequences of overheated equity markets. To certain investors, the chance of crisis in some asset somewhere seems all too likely.
Given this concern, many large institutions have been shifting toward risk mitigation, considering a range of strategies that might weather an incoming financial storm (Pensions & Investments, April 18, 2016).
Crisis is often associated with a drawdown in a local equity market. This tends to be seen as an unpredictable yet rare event. As investment increasingly becomes more global, with investors diversifying outside of their local equity markets and into further asset classes and regions, diversification provides some protection but also exposes other challenges. Crisis can happen anywhere at any time in any asset. Using quarterly data from late 1990 to 2016, I looked at the 10 worst quarterly returns for 17 global indexes across geographic regions and commodity sectors (Figure 1). For any given quarter, crisis occurs somewhere 63% of the time across regions, asset classes and commodity sectors. From this perspective, crisis becomes an unpredictable yet common event. Certain periods exhibit more stress than others, but across time there are many periods when several assets experience crisis. As a result, for the global investor, crisis is not a simple one-dimensional problem but a multiasset phenomenon. From a multiasset perspective, crisis is everywhere.
When more assets are in crisis, does this translate to more crisis alpha? To consider this, I divided quarterly returns into three groups: periods in which no asset is in crisis; periods in which only one to two assets are in crisis; and periods with multiple assets in crisis. If crisis creates potential opportunities for trend-following strategies, more assets in crisis could indicate more crisis alpha. To examine this concept, I plotted the average quarterly returns across the three crisis groupings for long-only global assets in comparison with CTAs and trend. Indeed, when more crises occurred across markets, global assets tended to suffer and trend-following strategies and CTAs found greater opportunities on average. On the other hand, when times are calm (i.e., no assets are in crisis), global assets tended to rally while trend-following strategies and CTAs have tended to struggle. This further demonstrates that crisis might be everywhere but more assets in crisis tend to imply more crisis alpha.
Given the performance of CTAs and trend-following strategies during periods when many assets are in crisis, I further examined where trend-following approaches find crisis alpha. A closer look at trend following performance by asset class (across equities, bonds, commodities and currencies) and by direction (net long or net short) supports the claim that trend following captures multiasset crisis alpha by actively trading a wide range of markets.
Secondly, the ability to take both long and short positions, at different speeds, allows trend-following strategies to adapt to difficult market environments with the potential to be better positioned to capture crisis alpha. In particular, short positions have tended to perform better during periods where many assets are in crisis.
In summary, actively trading a very diverse set of markets and being able to go both long and short allows a trend-following strategy the potential to capture crisis alpha wherever and whenever it might occur. For the global investor seeking risk mitigation, it is not surprising that trend-following strategies may provide a complementary profile.
Kathryn Kaminski is director, investment strategies, Campbell & Co., Baltimore. This content represents the views of the author. It was submitted and edited under P&I guidelines, but is not a product of P&I's editorial team.