Commentary: Crisis alpha – everyone likes the alpha, no one likes the crisis

History doesn't repeat itself, but it does tend to rhyme. Each crisis period in financial markets is unique with some aspects in common. In 2020, equity markets endured a devastating fall in the wake of concerns about the novel coronavirus followed by a miraculous recovery. To date, many investors are still asking: Was this recent period of turbulence a crisis that may continue or was this crisis a simple V-shaped correction, albeit rather painful? In a recent paper, we take a look at this spectacular market fall from the perspective of a trend-following strategy to determine what is similar and what is different from the crisis periods that came before.

Trend-following strategies take long and short positions following prevailing market trends across a wide range of asset classes, e.g., equity indexes, bond index futures, rates, currencies and commodities. These strategies have often been some of the few known to sometimes capture ever-coveted "crisis alpha."

A correction is a short-term loss that recovers relatively quickly. A crisis, on the other hand, is a prolonged period of market stress with sustained losses, which can occasionally come in waves. Using peak-to-trough losses in equity markets, we examined the speed (measured as total drawdown divided by time in a drawdown) for crisis periods since 1992. During this period, the tech crisis and (depending on how you look at it) the global financial crisis consist of several waves of drawdowns. Other crisis periods tended to be one-time events with varied depth and length (see Table 1).

To compare the crisis periods in Table 1, we plot the drawdowns graphically using circles to demonstrate the relative speed of each crisis period (see Figure 1).

In simple terms, the further right the bigger the pain, the further up the longer the pain. The bigger the bubble the faster it went. Pictures can paint a 1,000 words, and clearly from this picture the COVID-19 crisis was one of the fastest in recent history for a sizable market fall (other fast events were the reasonably short "volpocalypse" and the European debt crisis at only five days each). What has been even more spectacular is how quickly we have seen markets recover as many equity indexes have returned to prior valuations at record speed.

Trend followers are often associated with "crisis alpha" or opportunities gained during periods of market stress or dislocation. We examined how trend-following strategies might have fared in each crisis period. We found that across most crisis periods trend-following tended to have positive performance with varying results, hence their association with "crisis alpha."

We note a few key findings: Prior trend positioning in equities matters (i.e., how high you are on the mountain affects how far you fall); speed of trend measurement matters (i.e., the faster you can measure the faster you can move out of the way); and moving from a pure trend-following strategy to a more multistrategy approach also impacts the potential to capture crisis alpha (i.e., getting caught in things that tend to underperform in crisis can get in the way).

In 2020, there were sizable trends in fixed-income and commodity markets that led to positive returns for trend-following strategies. In simple terms, it seems like fixed-income markets and commodity markets had already started to move prior to the great equity fall that began after Feb. 21. In 2020, given the speed of the event, performance in equity trends for trend-following strategies depended, unsurprisingly, on the speed of measurement (those who moved faster got out of the path of a runaway train more quickly). As an example, Figure 1 plots the performance of fast trend-following system during each crisis period along with the equity position held by this strategy before the subsequent equity fall. Each crisis is indeed unique but clearly there are some similarities. For example, falling equities tend to drive trends across a range of asset classes.

In the first quarter of 2020, we saw large moves in many different asset classes, including persistent downward trends in commodities, a massive runup in bonds, a substantial equity market fall and sizable moves in currencies.

Since then, equity markets climbed back out of the deep trough; bonds corrected some then remained relatively range bound; commodities have reflated; and the U.S. dollar weakened. Figure 2 plots the risk-adjusted returns for each asset class to demonstrate the magnitude of these moves. For equities and currencies, we are roughly back where we started but net yields remain lower and commodities are still under pressure. In the short run, there two potential scenarios: sideways or sideways-to-down. Since the start of this crisis, immense fiscal and monetary policy measures have been initiated to steady the ship. In Figure 2, we can clearly see that asset returns have been more steady in the second quarter. The question is whether or not stimulus and government measures will be enough to hold out until economic conditions can come in line with current market valuations. Put more simply, a bigger concern is whether this crisis is like other, longer crisis periods in the past, which would mean the worst isn't over yet. We could easily face a potential second or third wave in financial markets if stimulus is unable to avoid massive value destruction.

2020 has been a challenging market environment for most investment portfolios. Few dynamic strategies seem able to navigate this high volatility, fear-driven and uncertain environment unscathed or at least without substantial emotional stress. Going into the final quarter of 2020 with commodity values reflating from low levels, interest rates mostly at near-zero to negative levels, the risk of inflation and other adverse scenarios continue to circulate in the minds of investors. As quant investors, we often think that every action has a subsequent reaction. Clearly, massive stimulus, negative rate policies and carry-on effects of a global health crisis will have a big impact, but where and how still remains unclear. Despite this, there should be global trends and potential for crisis alpha should we encounter further crisis events. One thing holds true: When it comes to crisis alpha, everyone likes the alpha but no one likes the crisis.

Kathryn M. Kaminski is the chief research strategist at AlphaSimplex Group LLC and Ying Yang is a junior research scientist at AlphaSimplex Group, both based in Boston. This content represents the views of the authors. It was submitted and edited under Pensions & Investments guidelines but is not a product of P&I's editorial team.