From the August 2014 issue of Investment Advisor • Subscribe!

Trend Following Isn't the Only Managed Futures Strategy

Counter-trend strategies are rising in popularity and can be a good complement to trend following

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The managed futures corner of the alternative investment space is one of the first places astute investors turn for diversification from traditional asset classes. Spurred by the research of a Harvard academic in the early 1980s who showed that managed futures funds have low to negative correlations to equities and fixed income products, hedge funds and institutional investors have been utilizing managed futures strategies for years. Traditionally, managed futures strategies have been associated with commodity trading advisors using trend-following systems to trade commodity futures contracts. However, there is also a niche of managed futures funds employing counter-trend trading models to trade a broad range of futures markets.

Trend following is undoubtedly the most common trading system employed by managed futures funds. In general, a trend-following system aims to invest in the direction of the long-term trend of a commodity, interest rate, exchange rate or equity index. A trend is considered the dominant direction for a market over a specified timeframe.

Trend following comes with a distinct statistical signature. For the most part, trend-following systems trade infrequently, have a low percentage of winning trades (25%-45%) and have a high winning-trade-to-losing-trade ratio (usually greater than 2). Additionally, trend-following systems tend to give back substantial profits at market turning points, and they are subject to whipsaw in directionless markets.

Counter-trend systems are less common, but offer a systematic framework that is equally as effective. Counter-trend systems generally have shorter-duration trades, a higher percentage of winning trades and a smaller win/loss ratio. A typical counter-trend strategy will trade more frequently than a trend-following strategy and produce 55% to 60% winning trades with a winning-trade-to-losing-trade ratio less than 1.5.

The majority of counter-trend models are looking to sell short-term overbought levels and buy short-term oversold levels. This behavior allows counter-trend models to thrive in volatile markets and to react quickly to market turning points. The drawback is that they often struggle in steady, trending environments.

While trend following has historically been the most common system employed by managed futures funds, counter-trend trading models are rising in popularity. Because they use different trading methodologies than trend-following strategies, together the two can provide greater diversification.

As shown in the chart above, the correlation between the Newedge trend-following index and a simple 10-day high/low counter-trend model was -0.05 for the period measured. Low correlations among asset classes are hard to come by, so combining two non-correlated strategies provides investors with an effective diversification opportunity.

As advisors evaluate managed futures strategies, they need to understand why and when each strategy should work. All trading strategies have environments in which they perform well and in which they struggle. A keen understanding of a strategy's mechanics and thesis will help an advisor construct a well-rounded portfolio of managed futures strategies and remain steadfast during good and bad environments.

Trend-following strategies are adept at capturing strong, sustained price movements, while counter-trend strategies are better equipped to handle sporadic pockets of volatility. A balanced allocation to both strategies would have been able to capitalize on the crisis in 2008 and still react to the pockets of volatility that have been scattered throughout the markets as they marched upward from the lows in 2009.

Overall, advisors who take the time to understand the nuances of a strategy will be better equipped to build and hold portfolios for the long term.

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