A half-century of trend-following - How CTAs make money in different yield curve regimes

A long-term empirical analysis of trend-following returns

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Diversified trend-following relies on the premise that persistent trends can be captured in all types of markets and across all asset classes, independent of a specific market environment. This note focuses on analyzing and quantifying the opportunity set of profitable trends in bonds, equities, commodities and FX as a function of the term structure characteristics of US interest rates. Using a generic trend-following model and relying on a representative investment universe covering close to 50 years of price history across the bond, equity, commodity and currency markets, we quantify the opportunity set offered by each asset class under four different interest rate term structure scenarios. We show that while the bond future opportunity set for a trend-follower has been naturally reduced in an environment of rising yields, it was usually compensated by increased opportunities in other asset classes. We further break down these results by the level of interest rate carry and highlight that a rising rate regime associated with a high level of carry is the most challenging environment from a trend-following perspective. This is partially explained by the fact that it has been more difficult to capture upward trends in bond yields since the 1990s, as these trends have been more whipsawed. In addition, a high carry corresponds to a premium and hence reduced profitability of holding short positions in bond futures, from which trend-followers would usually benefit in a rising rates scenario. On the other hand, an environment of persistently declining yields may offer much stronger and at times exceptional trend opportunities in bonds, which are even more reinforced by a high carry. This was particularly the case in recent years, when bond markets contributed a large part of the positive trend-following returns. While this environment is unlikely to persist for much longer, the unusually low contribution from currencies and commodities could also come to an end. In the four decades between 1970 and 2000, three-quarters of trend-following returns originated from asset classes other than fixed income. The most striking result from our long-term analysis is that trend-following returns were consistently positive and surprisingly similar in all scenarios except the one mentioned above with rising rates and high carry. Our results confirm and highlight the importance of a diversified approach to trend-following across all main liquid asset classes in order to achieve the best possible long-term risk-adjusted returns.

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Quantica Capital
December 3, 2020