How do the long and short sides of futures trend-following strategies differently affect portfolio riskiness? In their September 2016 paper entitled “The Long and Short of Trend Followers”, Jarkko Peltomaki, Joakim Agerback and Tor Gudmundsen-Sinclair investigate via linear regression behaviors of the long and short sides of commonly used trend-following strategies across equities, bonds, commodities and currency futures/forwards under different economic conditions. They model trend-following performance by combining two sets of rules: (1) four slow-reacting simple moving average pair crossover rules using 75-225, 100-300, 125-375 or 150-450 daily moving average pairs; and, (2) four fast-reacting moving average breakout rules based on fluctuations around a long-term moving average. They apply the same allocation method for all rules to set a constant initial risk per trade, adjusted daily by scaling inversely with volatility. They examine how long and short trend-following returns depend on economic environment, focusing on interest rates. They assume trading frictions total $30 per contract. Using futures contract data for 22 equity indexes, 15 government bonds, 17 commodities and six currencies relative to the U.S. dollar, and contemporaneous Commodity Trading Advisor (CTA) performance indexes, during 1984 through 2015, they find that:
- Overall, futures trend-following strategies perform best when interest rates decline, suggesting similarity to a long bond strategy. However, long and short sides respond in different degrees, introducing overall interest rate risk. Specifically:
- Long (short) bond trend-following performs very poorly (well) when rates rise. The effect is very strong for long bond, which drives multi-asset class results.
- Long (short) equity trend-following performs well (poorly) when rates rise. The effect is stronger for long equity than short equity.
- The effect is relatively weak for commodity and currency trend-following.
- Equity and commodity futures trend-following returns relate positively to the equity momentum factor, but bond and currency futures trend-following portfolios do not.
- The trend-following performance model explains about two thirds of aggregate CTA performance behaviors, higher during the latter part of the sample period than earlier. Comparison of model outputs to CTA indexes suggests that CTAs:
- Underperform the mechanical model on average.
- Perform best when interest rates are high.
- Have a long bias, particularly for equities and bonds, introducing interest rate risk.
- Do not account for the different interest rate exposures of the long and short sides.
- Have marked long bond exposure and elevated interest rate risk after the 2008 financial crisis.
In summary, evidence suggests that investors employing futures trend-following hedge portfolios should understand their interest rate sensitivity and, in particular, the different interest rate sensitivities of the long side and short sides.
Caution regarding findings include:
- Interest rate sensitivity analyses are contemporaneous. Exploiting findings by taking interest rate risk depends on accurate interest rate predictions.
- The sample period is a secular bond bull market (mostly declining interest rates). Including an extended period of rising rates in the sample could alter findings.
