Are trend-following CTAs truly long volatility?

Quantifying the relationship between asset class volatility regimes and trend-following returns.

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This note quantifies the asset class return contribution and total performance of a medium-to-long-term trend- following strategy during different asset class volatility regimes, and not only restricted to equity volatility. Our lookback period from 2000 to 2023 covers bull markets, bear markets, market crises and quiet times of generationally low volatility across all major asset classes.

Starting with equity market volatility, we show that all three (low, normal, and high) VIX Index regimes contribute positively to a medium-to-long-term trend-following strategy’s returns. We highlight that the average trend- following contribution during low and high VIX quarters are higher than during normal VIX quarters. While the average trend-following returns in the low- and high-VIX regimes are higher than in normal VIX regimes, asset class attribution reveals surprisingly different return drivers during the two extreme volatility regimes.

The VIX only measures expected U.S. equity volatility, and using realized volatility across a diversified range of markets shows a result that is generalized across asset classes: low volatility regimes are more conducive to overall trend-following returns. Extending the analysis beyond equity volatility to bond, commodity, and currency volatility is important because on average, the overlap between periods of high or low volatilities for these asset classes is less than 50%. 2023 has demonstrated this very well with above average bond volatility but below average equity volatility. We show that as with the VIX Index, both high and low volatility regimes for all asset classes have contributed positively. In addition, and maybe counterintuitive to some, periods of low volatility tend to deliver higher overall returns than periods of high volatility. This result is consistent across all asset classes.

Going one step further, we investigate asset class return contributions with respect to each asset class’s volatility regimes and again find consistent results for all four asset classes: the trend-following opportunity set is well- balanced amongst asset classes during normal volatility regimes, whereas both high and low volatility regimes create highly divergent opportunities between asset classes.

We conclude that trend-following CTAs are well suited to provide strong “smart diversification” characteristics during different volatility regimes for all four asset classes.

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Quantica Capital
December 5, 2023