The Big Hedge-Fund Strategy That Isn’t Working
Despite terrible returns, so-called trend-following funds have attracted $300 billion in assets
Following trends in financial markets was once one of the most profitable investment strategies around. Now the approach is being battered as cheap replica funds crowd into the space.
Performance among the roughly $300 billion in hedge funds that largely use so-called trend-following strategies has been abysmal. An investor buying into these funds at the start of 2011, for instance, and holding through July this year would have lost 3.4% on average, according to HFR. Over the same period the S&P 500 is up 124%.
“It’s like a lot of industries,” said Matthew Beddall, founder of investment firm Havelock London. “As it’s been successful more people have got involved. Now you can buy a book on Amazon on how to code trend-following.”
Trend-following is a simple concept with complex execution. The underlying idea is relatively straightforward: If a security is going up—usually measured by a short-term moving average rising above a long-term moving average—then it’s time to buy. If it falls below, it’s time to sell. Funds employ armies of Ph.D. scientists to work out exactly when a price move becomes a trend.
Investors have followed trends for centuries. British economist David Ricardo, who amassed a fortune trading markets 200 years ago, was known for cutting his losing positions and running his winners. Trend-following took off as a hedge-fund strategy in the 1980s, when commodities brokers automated trading with computers to look for market patterns.
These funds chalked up double-digit gains during the 1990s and 2000s. And they were one of the few hedge-fund strategies to make money in 2008’s market slump. This performance led pensions and other hedge-fund investors to pour in money.
The strategy has failed to deliver in recent market falls. In January, many such funds made big gains as markets soared, only to lose them and more during February’s volatility-driven selloff.
It isn’t entirely clear why it has stopped working. Some point to the cash that has flooded into the sector, believing overcrowding has eroded returns. Assets have more than tripled over the past decade, according to HFR. Others say quantitative easing has suppressed the volatility these funds enjoy, or that the near-instantaneous distribution of news via the internet means investors react quicker and trends, therefore, don’t last as long.
The strategy, also known as managed futures or CTAs (commodity trading advisors), has helped turn traders such as John Henry, owner of the Boston Red Sox, and David Harding, head of hedge fund Winton Group, into billionaires.
The success has encouraged investment firms to offer lower-cost alternatives. Research Affiliates licenses out its strategies to other firms. AQR Capital Management LLC runs a $15.4 billion trend-following strategy and other, similar portfolios. Amundi Asset Management and GAM Holding AG produce their own low-cost versions—often called alternative risk premia.
“Eighty percent, maybe 90% of the characteristics of this strategy can be captured with a solid set of rules and a solid implementation,” said Leda Braga, founder of $8.5 billion trend-following hedge fund Systematica. Her flagship hedge fund has cut fees and the firm last year launched a lower-cost trend-following fund.
“There’s a fee compression in this space” driven by investors recognizing trend-following is becoming commoditized, said Ms. Braga. She said her firm has become a low-margin business.
Trend-following is one of the starkest examples of how strategies that once belonged exclusively to hedge funds and earned them huge profits are being copied and commoditized by low-cost replicators.
Winton’s flagship hedge fund once focused almost solely on trend-following, but its declining effectiveness has persuaded it to reduce that over time to around half of the portfolio. It plans to reduce that to around one-quarter by next year. Winton is instead launching a separate trend-following fund for clients who still want that.
Despite the patchy performance, investors are keeping the faith alive in trend-following. Surging interest in computer-driven investing has helped, as has demand for funds uncorrelated to stock markets, and strong returns in 2008 and 2014. Funds such as Winton have pulled in assets thanks to stronger-than-average performance.
Fund managers are going into more exotic realms to escape the overcrowding. Doug Greenig, a former chief risk officer at trend-follower AHL, overhauled his hedge fund, Florin Court, to focus solely on hard-to-access markets he sees as less crowded, such as onshore futures in China and cryptocurrencies.
Systematica’s Ms. Braga argues the strategy isn’t overcrowded but admits “I don’t know, I don’t know,” when asked why trends haven’t been present in markets in recent years.