TREND FOLLOWING WITH MANAGED FUTURES Founded in 1807, John Wiley & Sons is the oldest independent publishing company in the United States With offices in North America, Europe, Australia and Asia, Wiley is globally committed to developing and marketing print and electronic products and services for our customers’ professional and personal knowledge and understanding The Wiley Trading series features books by traders who have survived the market’s ever changing temperament and have prospered—some by reinventing systems, others by getting back to basics Whether a novice trader, professional or somewhere in-between, these books will provide the advice and strategies needed to prosper today and well into the future For more on this series, visit our Web site at www.WileyTrading.com TREND FOLLOWING WITH MANAGED FUTURES The Search for Crisis Alpha Alex Greyserman Kathryn Kaminski Copyright © 2014 by Alex Greyserman and Kathryn Kaminski All rights reserved Published by John Wiley & Sons, Inc., Hoboken, New Jersey Published simultaneously in Canada No part of this publication may be reproduced, stored in a retrieval system, or transmitted in any form or by any means, electronic, mechanical, photocopying, recording, scanning, or otherwise, except as permitted under Section 107 or 108 of the 1976 United States Copyright Act, without either the prior written permission of the Publisher, or authorization through payment of the appropriate per-copy fee to the Copyright Clearance Center, Inc., 222 Rosewood Drive, Danvers, MA 01923, (978) 750-8400, fax (978) 646-8600, or on the Web at www.copyright.com Requests to the Publisher for permission should be addressed to the Permissions Department, John Wiley & Sons, Inc., 111 River Street, Hoboken, NJ 07030, (201) 748-6011, fax (201) 748-6008, or online at http://www.wiley.com/go/permissions Limit of Liability/Disclaimer of Warranty: While the publisher and author have used their best efforts in preparing this book, they make no representations or warranties with respect to the accuracy or completeness of the contents of this book and specifically disclaim any implied warranties of merchantability or fitness for a particular purpose No warranty may be created or extended by sales representatives or written sales materials The advice and strategies contained herein may not be suitable for your situation You should consult with a professional where appropriate Neither the publisher nor author shall be liable for any loss of profit or any other commercial damages, including but not limited to special, incidental, consequential, or other damages For general information on our other products and services or for technical support, please contact our Customer Care Department within the United States at (800) 762-2974, outside the United States at (317) 572-3993 or fax (317) 572-4002 Wiley publishes in a variety of print and electronic formats and by print-on-demand Some material included with standard print versions of this book may not be included in e-books or in print-ondemand If this book refers to media such as a CD or DVD that is not included in the version you purchased, you may download this material at http://booksupport.wiley.com For more information about Wiley products, visit www.wiley.com ISBN 978-1-118-89097-4 (Paperback) ISBN 978-1-118-89104-9 (ePDF) ISBN 978-1-118-89102-5 (ePub) CONTENTS Foreword Preface Introduction A Foreword for the Remainder of the Book Part I: Historical Perspectives Chapter 1: A Multicentennial View of Trend Following The Tale of Trend Following: A Historical Study Return Characteristics over the Centuries Risk Characteristics over the Centuries Portfolio Benefits over the Centuries Summary Appendix: Included Markets and Relevant Assumptions Further Readings and References Part II: Trend Following Basics Chapter 2: Review of Futures Markets and Futures Trading Forward and Futures Contract Fundamentals Review of the Managed Futures Industry Futurization Summary Further Readings and References Chapter 3: Systematic Trend Following Basics The Basic Building Blocks of a Trend Following System Strategy Classification and Core Differentiators Partitioning Trend Following Systems Summary Further Readings and References Part III: Theoretical Foundations Chapter 4: Adaptive Markets and Trend Following The Adaptive Market Hypothesis A Framework for Speculative Risk Taking A Closer Look at Crisis Alpha Summary Further Readings and References Chapter 5: Divergence and the Tradability of Trend Risk versus Uncertainty Convergence versus Divergence Measuring Market Divergence at the Portfolio Level Testing the Stationarity of Market Divergence The Tradability of Trend The Importance of Entry versus Exit Summary Further Readings and References Chapter 6: The Role of Interest Rates and the Roll Yield Collateral Yield Decomposition into Roll Yield and Spot Summary Further Reading and References Part IV: Trend Following as an Alternative Asset Class Chapter 7: Properties of Trend Following Returns Trend Following as an Alternative Asset Class Crisis Alpha Crisis Beta Key Statistical Properties Summary Appendix: A Summary of Common Performance Measures Further Readings and References Chapter 8: Characteristics of Drawdowns, Volatility, and Correlation Understanding the Properties of Drawdowns Volatility of a Trend Following Portfolio Correlation and Diversification at the Portfolio Level Summary Further Readings and References Chapter 9: The Hidden and Unhidden Risks of Trend Following Directional and Nondirectional Strategies: A Review Defining Hidden and Unhidden Risks The Myths and Mystique of the Sharpe Ratio Unraveling Hidden Risks of Dynamic Leveraging Summary Further Readings and References Chapter 10: Trend Following in Various Macroeconomic Environments Interest Rate Environments Regulatory Forces and Government Intervention Postcrisis Recovery Summary Further Readings and References Part V: Benchmarking and Style Analysis Chapter 11: Return Dispersion Strategy Classification and Return Dispersion A Closer Look at Capital Allocation and Position Sizing Return Dispersion from an Investor’s Perspective Empirical and Theoretical Considerations for Correlated Return Series Summary Further Readings and References Chapter 12: Index and Style Factor Construction Divergent Risk Taking Revisited Defining a Divergent Trend Following Strategy Constructing Style Factors Characteristics of the Style Factors Summary Further Reading and References Chapter 13: Benchmarking and Style Analysis A Framework for Return-Based Style Analysis Style Analysis for Individual CTA Managers Sector Level Analysis of the Market Size Factor Style Analysis Clarifications Manager Selection and Allocation Summary Further Readings and References Part VI: Trend Following in an Investment Portfolio Chapter 14: Portfolio Perspectives on Trend Following A Closer Look at Crisis Alpha The Impact of Mark-to-Market on Correlation Understanding Volatility Cyclicality Summary Further Readings and References Chapter 15: Practicalities of Size, Liquidity, and Capacity Does Size Matter? The Impact of Less Liquid Markets Summary Appendix: Market Symbols and Names Further Readings and References Chapter 16: Diversifying the Diversifier From Pure Trend Following to Multistrategy Portfolio Analysis of the Move to Multistrategy Hidden Risk of Leveraging Low-Volatility Strategies Summary Further Readings and References Chapter 17: Dynamic Allocation to Trend Following A Framework for Dynamic Allocation Mean Reversion in Trend Following Return Series Investigating Dynamic Allocation Strategies Summary Appendix: A Theoretical Analysis of Mean Reversion in Trend Following Interquartile range: defined return dispersion Investor perspectives: crisis alpha overview cyclicality, understanding dynamic allocation history of trend following introduction liquidity as factor market size as factor market symbols and names mark-to-market impact measuring divergence multistrategy approach return dispersion summary Irreducible uncertainty J Japan, government intervention JPM Global Bond Index: investor perspectives multistrategy approach return properties K Knightian Uncertainty KPSS test L Lagged measures, use of Leverage risk: multistrategy approach overview Sharpe ratio myths and mystique Leveraging, dynamic See Dynamic leveraging Limit orders, described Liquidity: commodities vs financials correlation and defined introduction investor perspectives measuring diversification benefits summary Liquidity providers Liquidity risk: forward contracts linking uncertainty to overview Sharpe ratio myths and mystique Long equity bias See Equity long bias Long-term strategy type Lookahead windows, defined Lookback straddle options, dynamic allocation Lookback windows: described market size factor return dispersion rolling windows of crisis alpha Loss tolerance, defined M Macroeconomic environments: correlation and diversification government intervention as history of trend following interest rate environments as introduction postcrisis recovery as regulatory forces as summary Maintenance margin, described Managed futures industry See also specific aspects growth introduction strategies Manager characteristics Manager performance, extracting dynamic leveraging Manager selection and allocation, style analysis Managers, style analysis for Margin accounts, described Margin call, described Margin to equity ratios futures markets and trading overview Market allocation component Market beta: in Fama-French model understanding Market bubbles and crises See Financial bubbles and crises Market capacity approach, index and style factor construction Market capacity weighted index, style analysis Market capacity weighting, trend following systems Market correlation See also Correlation key definitions portfolio theory Market dislocation, defined Market divergence index See also Divergence defined described investor perspectives measuring at portfolio level roll yield and style analysis testing stationarity Market diversification benefit Market for trend following, defining Market functionality, adaptation and Market orders: described trend following systems Market risk See Price risk Market size factor: correlation and diversification introduction investor perspectives manager selection and allocation overview sector level analysis style analysis clarifications style analysis for individual managers style analysis framework style factor characteristics summary Market symbols and names Market volatility See also Volatility changes in key definitions portfolio theory return dispersion and Mark-to-market: futures markets and trading overview impact on correlation Martingale betting: dynamic leveraging and investor perspectives margin to equity ratio Maximum drawdowns: described expected maximum drawdown history of trend following investor perspectives Mean reversion strategies: analysis of described introduction in return series Medium-term strategy type Model design, style analysis Momentum seeking strategies: described divergence and introduction momentum as concept performance of return properties and Momentum, time series See Time series momentum Monte Carlo simulation: drawdowns return dispersion Monthly return skewness Moving average crossover strategy: return dispersion trend following systems Moving average strategy, trend following systems MSCI World Index: investor perspectives multistrategy approach return properties trend strength and volatility MSCI World Total Return Index, adaptive markets Multicentennial view of trend following See History of trend following Multistrategy approach: crisis alpha disparity of portfolio benefits fund-of-funds investors hidden risks of leveraging introduction move from pure trend following negative skewness robustness of portfolio benefits Sharpe ratios 60/40 investors summary Mutual fund evaluation, using Fama-French model N National Futures Association Natural selection, cycle of Negative convexity, defined Negative skewness: good volatility history of trend following multistrategy approach Net convenience yield, described Newedge CTA Index, style analysis Newedge Index: style analysis volatility Newedge sub-Trend Index: adaptive markets good volatility Newedge Trend CTA Index, adaptive markets Newedge Trend index: investor perspectives style analysis Newedge Trend Indicator: index and style factor construction style analysis Nobel Prize Nondirectional strategies See also Risks of trend following defining risks multistrategy approach review of strategies Nontrend and smaller managers, style analysis for Nontrend strategy type O Oil price examples: futures markets and trading overview government intervention trend following systems Omega ratios, defined Optimization with uncertainty Option selling strategies, dynamic leveraging and “Outside the black box” concept Over-the-counter derivatives P Partitioning, trend following systems Percentage of winning markets, calculation of Performance attribution, style analysis Physics envy Point value, use of Portfolio benefits: history of trend following investor perspectives robustness of Portfolio correlation See also Correlation key definitions at portfolio level portfolio theory Portfolio level: correlation and diversification at correlation and volatility at measuring divergence at Portfolio perspectives See Investor perspectives Portfolio volatility See also Volatility key definitions market volatility changes portfolio theory trend strength and Position selectivity, index and style factor construction Position sizing: entry vs exit return dispersion trend following systems Positive convexity, defined Positive skewness: good volatility history of trend following multistrategy approach return properties Price risk: overview Sharpe ratio myths and mystique Probability matching, described Punctured equilibrium, defined Pure trend following, defined R Random entry system: divergence return dispersion Random Walk Indicator Random walk strategies, described Realized dollar risk, described Recovery period, described Recovery time, expected Regulatory forces: futurization and as macroeconomic environment Relative value strategy type Resistance, defined Return-based style analysis See Style analysis Return characteristics, history of trend following Return dispersion: capital allocation and position sizing empirical and theoretical considerations introduction investor perspectives as key property strategy classifications summary Return dispersion index, measuring Return properties: alternative asset classes crisis alpha crisis beta introduction key statistical properties summary Returns, decomposition of Return series, mean reversion in Risk: defined uncertainty vs volatility as concept Risk allocation, index and style factor construction Risk characteristics, history of trend following Risk management tools Risks of trend following: decision making and defining hidden and unhidden risks directional and nondirectional strategies dynamic leveraging introduction multistrategy approach Sharpe ratios and summary Risk targets, trend following systems Risk to uncertainty ratio, described Robust optimization field Roll yield, interest rates and S Sector allocation, trend following systems Sector bias, trend following systems Sector directional bias, trend following systems See also Equity long bias Sector level analysis of market style factor Sector specific crisis alpha See also Crisis alpha Serial autocorrelation: drawdowns overview dynamic allocation investor perspectives risks of trend following Sharpe ratios: defined drawbacks of dynamic allocation investor perspectives multistrategy approach postcrisis recovery risks of trend following Shiller, Robert Short selling, history of trend following Short-term strategy type Signal generation and aggregation, trend following systems Signal observation period, defined Signal to noise ratio, described Simulation, return dispersion and 60/40 investors: history of trend following investor perspectives multistrategy approach Size factor, in Fama-French model See also Market size factor Sizing function, described Skewness: defined good volatility history of trend following monthly return skewness multistrategy approach return properties Smaller and newer markets, market size factor Smaller and nontrend managers, style analysis for Smell, risk and Social networking example S&P 500 index: drawdowns investor perspectives postcrisis recovery price risk return properties style analysis Speculation, futures markets and trading overview Speculative opportunities, described Speculative risk premiums, described Speculative risk taking framework, adaptive markets Speed of trading as factor See Trading speed factor Spot prices: decomposition into roll yield and spot futures markets and trading overview SPX (index), investor perspectives Standard deviation as metric Stationarity: of divergence of trend leakage Sterling ratio, described Stop loss orders, described Strategy correlation See also Correlation key definitions portfolio theory Strategy returns, key definitions See also Return headings Strategy volatility See also Volatility key definitions market volatility changes portfolio theory trend strength and Street crossing example Style analysis See also Index and style factor construction baseline strategy and model design clarifications Fama-French model overview framework for for individual managers introduction manager selection and allocation of market size factor summary Style drift, monitoring Success rates, described Support levels, defined Swap futures, described Systematic trend following See Trend following systems Systemic strategy type T Tail hedging field Tail risk multiplier, defined Target risk, trend following systems TED spread Theoretical foundations: adaptive markets divergence and tradability of trend interest rates and yield Tightness of trailing stop Time series momentum: adaptive markets described index and style factor construction Time to recovery, as investor concern Time weighted average price, described Tinkering process Total adjusted dollar risk, described Total notional exposure, capital allocation comparison Tradability of trend: entry as focus exit as focus introduction summary Trading execution component Trading range, described Trading signals, defined Trading speed factor: investor perspectives manager selection and allocation overview style analysis clarifications style analysis for individual managers style analysis framework style factor characteristics trend following systems Trading volume, growth of Trailing stop: defined tightness of Trailing stop indicator, defined Trailing stop loss tolerance, defined Treasury bill investments See also Interest rates adaptive markets collateral yield Treasury bond investments See also Interest rates macroeconomic environments Trend beta: style analysis understanding Trend following returns See Return headings Trend following squared Trend following systems: basic building blocks data processing defined introduction market allocation partitioning position sizing sector allocation signal generation and aggregation strategy classification and differentiators summary trading execution Trend leakage Trend seeking vs trend following Trend signals, signal generation and aggregation Trend size: defined measuring Trend strength: defined trend following systems volatility and TSMOM (index), style analysis Tulip bubble example Turkish Lira exchange rate U Uncertainty: adaptive markets defined linking to liquidity and credit risks optimization with risk vs volatility as concept Unexplained volatility, defined Unhidden risks See Risks of trend following United Kingdom: inflationary environments market behavior examples street crossing example United States: collateral requirements futurization government intervention inflationary environments managed futures industry market behavior examples United States Short Oil Fund V Value-at-risk measure Value loading, in Fama-French model Variance ratio statistic, dynamic allocation Variation margin, described Vega neutral, systems as Velocity of divergence: examining stationarity of VIX (index): dynamic leveraging investor perspectives return properties Volatility: concept of convergence vs divergence correlation and good volatility history of trend following key definitions market volatility changes measuring market divergence multistrategy approach portfolio theory return dispersion and return properties and summary trend strength and uncertainty and Volatility cyclicality, investor perspectives W Wall Street crash of 1929 Wheat price example Win-loss ratio of PnL, calculation of Win/loss ratios, drawdowns and Winning percentage and return Winning ratio of trades, calculation of WILEY END USER LICENSE AGREEMENT Go to www.wiley.com/go/eula to access Wiley’s ebook EULA