2024…a Year like No Other!
- High volatility is likely to continue throughout 2024. Systematic investors should expect sharp market undulations and inflation rates remaining above the Fed’s target.
- With the stock market yielding below-average returns in the past few years, more investors have turned to structured products and options trading. Experts see some risk in the options market as higher volumes increase the implied volatility
- The right blend of trend and non-trend strategies depends on the objectives of an individual investor. Top Traders Unplugged’s co-hosts explain how to think about diversification in a trend-following investment strategy.
Remember the U.S. regional banking crisis in March 2023? In less than a week, three mid-sized banks collapsed, sending shockwaves throughout the financial world and plunging managed futures into a nosedive.
But if those hectic days have already blended into the background of your memory, it’s no surprise. Extreme events were the norm of 2023, driving wild price swings and sharp movements. It wasn’t the easiest year for systematic investors to manage trend-following strategies, and the high volatility looks here to stay for the foreseeable future.
As we move into the new year amid swirling questions about inflation, monetary policy and geopolitical instability, our Top Traders Unplugged co-hosts joined a special edition of the Systematic Investor Series to offer their perspectives on how to approach trend following and what pitfalls to avoid in a high-volatility environment. Here are seven themes steering 2024 investment strategy that every trader should watch.
Fixed income in focus
To start, bonds are back — and so is the potential long-bond bias for trend followers. For most of the last twenty years, bonds have been a safe, tried-and-true hedge against the stock market. Normally, long bonds, those with maturity dates far into the future, have delivered higher yields than their short-dated counterparts. Then, of course, 2022 brought its historically awful bond market performance, challenging the assumption that long bonds are a strong portfolio inclusion.
As 2023 saw fixed-income strategies recover a bit of ground, some trend followers are perhaps returning to that long-bond bias too soon. Although not as pronounced as 12 months ago, U.S. Treasury bonds still have an inverted yield curve. The benchmark 10-year Treasury note cleared a 5% yield in October, but then came back down as the market consolidated. Our trend-following performance report shows that there’s no guarantee that bonds and equities will return to their uncorrelated relationship in the coming months.
Katy Kaminski notes that although long-bond bias had a negative impact on trend in 2023, long bonds shouldn’t be off the table in 2024. “For me,” she says, “ is a year of consolidation, a year of moving towards the next trend and following fixed income.” Were the Fed to reverse course on its interest rate hikes, we could quickly see a normalized bond yield curve. At the center of that discussion, of course, is inflation.
“There are a lot of clues underneath the hood that structural inflation is still very strong,” says Cem Karsan. Among the reasons is the growing service economy, which is typically more resistant to rate hikes than the manufacturing sector, along with a strong labor market, deglobalization and commodity scarcity.
“Much like in the 1970s and other periods before, [inflation] is a function of populism and rebalancing. I think that’s a critical thing for people to understand. It’s not just the fiscal [policy],” Cem adds. For trend followers, it’s worth anticipating price swings based on the mismatch between deflationary expectations and reality.
The Federal Reserve has hinted at plans for rate cuts in 2024, but most experts agree that central banks will proceed cautiously as long as core inflation rates remain above target. This foretells that a “higher for longer” inflation environment will potentially slow equities markets, as rate decreases certainly won’t happen at the same pace the rate hikes did. In practice, this means trend followers should get ready for another year of quick price swings.
Year of the whipsaw
When the central bank pulls back from economic stimulus, a process known as tapering, bond prices typically fall, which means yields go up. Andrew Beer explains, “What [we’ve] seen since [fall 2023] are these incredibly sharp moves where every time there’s a hint of the taper [from the Federal Reserve], people are rushing to reload on [high] duration.” Investors want relatively discounted bonds with high returns, and they jump when they think a taper’s on the horizon.
But the reverse is also true. Whenever there’s a hint of recession, the possibility of the Fed’s lowering rates to stimulate the economy throws the bond market hard in the opposite direction. Andrew calls 2023 “the year of the whipsaw,” referring to the abrupt, unexpected moves in a highly volatile market. “The behavior culture is driving the volatility,” he says, as rumors and headlines cause frantic price fluctuations.
Katy agrees that 2024 will likely be another year of high volatility. Her advice is to avoid looking for the top and bottom of a market undulation — and instead focus on the trend the market is moving into next. “We’ve moved to a new phase of the interest rate trade,” she says. Many institutional investors are positioning for a central bank rate decrease in 2024 after two years of rate hikes.
If it’s been a whipsaw for stocks and bonds, how about derivatives? Cem says, “One of the biggest things that’s happened broadly across markets is the acceleration of volumes in the options market, particularly 0DTE (zero-days-to-expiration).” 0DTE options typically have a tight spread but can offer a significant profit if the trader correctly predicts the underlying asset’s movement before the closing bell. In 2023, 0DTE options strategies accounted for more than 40% of all options trading on the S&P 500. Cem attributes the 0DTE interest to two main causes.
First of all, options offer more profit opportunities when the stock market is sluggish. “The last two years of [stock market] performance obviously haven’t done very well as opposed to the fifteen years before when we saw on average 12% annual returns,” Cem says. A winning option trade might make as much in a few hours as months of waiting in the stock market.
Secondly, 0DTE trades can, in theory, avoid the volatility roller coaster described above. Instead of wondering how far up or down an option might swing over a period of weeks, investors can look at a much smaller window of price fluctuations in just a single day. But as there’s an increased transaction volume, the implied volatility — or likely movement — of the option goes up as well.
“There’s not enough regulation that’s caught up with [0DTE]. There’s not proper margining,” Cem says. “The massive amount of volume is dangerous.” Whether it’s a group of retail day traders speculating or an institution trying to hedge a position, the massive 0DTE volume can have a cascading, albeit short-lived, effect on stock prices. For systematic investors, it’s important to be wary of these sharp expiry-day movements.
Besides options, another alternative to an unappealing equities market is structured products. These bank-issued, prepackaged investment products offer safe, high-yield returns for investors while banks effectively absorb the volatility risk. When inflation peaked in the 1970s, these investment options didn’t exist. Now, we’re seeing the impact they have on markets during a period of high interest rates.
Cem explains, “[Structured products] ironically [have] a feedback loop that is dampening volatility at the core at the center of markets, which is the index itself.” The banks have derivative components baked into their structured products. But because the products don’t pay until a maturity date, there’s a level of stability for the investor, who isn’t making trades day to day.
Yet while a degree of stability comes to the stock index, high interest rates can broadly drive up volatility in other places, such as FX trades, precious metals or commodities. “If interest rates go down,” Cem says, “you’re actually going to see the opposite.” Index funds will likely become more volatile as structured products become less attractive in a low-rate environment, while volatility in other places will subside. It’s a pattern to consider with rate cuts on the horizon.
With so much discussion on trend following, what about non-trend strategies? Instead of focusing solely on following trends in commodity trading, for example, investors might mix in some smooth returns with a fixed-income strategy as a way to decrease risk. Rob Carver says, “Generally speaking, if you add non-trend [strategies], you’re going to push up your Sharpe ratio,” referring to the common method of measuring risk-adjusted returns.
But Rob admits there is a diminishing return to trying to add non-trend strategies for risk management. Richard Brennan challenges the idea that non-trend investments inherently make a strategy more diverse, given that trend following is already tracking price movements in so many arenas.
“Trend is already very globally diversified,” Rich says. “When you are therefore allocating into non-trend, my counterargument to this would be, are we making the portfolio possibly less diversified?” The invitation here is to look closely at how correlated — or uncorrelated — the different strategies in a portfolio are.
Nick Baltas adds, “To the extent possible, minimize [anti-trend] exposures so that the addition of a new theme is purely additive, at least from a performance and operation perspective.” Unlike the traditional view of stocks and bonds, which can hedge each other, trend and non-trend should both add value — not cancel each other out.
Alan Dunne reminds that risk appetite will depend on investment goals, but for those looking for smoother returns in 2024, non-trend strategies are a worthwhile avenue to explore.
Finally, hedge fund managers should think about how best to communicate with investors about trend strategies. Is trend just about pattern recognition or quick actions on market moves? When explained poorly, trend following sounds like gambling or just acting on a hunch. Richard says vagueness about how a strategy works can erode trust. “Fuzziness doesn’t really help. The allocator doesn’t really help the consumer,” he notes.
Practically speaking, fund managers can communicate the asset class they’re trading and what indicators they’re using to open a position. Andrew even advises a rephrasing of “trend” based on the success of other terminology changes.
“Junk bonds became high-yield bonds. Leverage sounded really scary, so it became private equity. Asset-based lending became private credit. So most allocators just need a simple construct or a name,” he says.
Andrew suggests phrasing trend following as finding an “opportunistic” entry point. After all, while high volatility can make it seem like investing is anyone’s guess, the right strategy can certainly capitalize on profitable opportunities.
This is based on an episode of Top Traders Unplugged, a bi-weekly podcast with the most interesting and experienced investors, economists, traders and thought leaders in the world. Sign up to our Newsletter or Subscribe on your preferred podcast platform so that you don’t miss out on future episodes.
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