Whose Sharpe Should We Optimize?

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This summary is written by Rich based on a conversation in our CTA series between Yao Hua Ooi, Co-Head of Macro Strategies at AQR, and  the podcast hosts, Niels and Alan.

About AQR Capital Management

Alan Dunne and Niels were joined by Yao Hua Ooi, Co-Head of Macro Strategies at AQR, to discuss trend following and managed futures. 

AQR is a large quantitative asset manager founded in 1998, approaching its 25th anniversary. The firm manages about $100 billion, with over half in traditional long-only equity portfolios and the rest in various alternatives. Trend following strategies have been run by AQR since 2008 and constitute an essential part of their business, representing around $4 to $5 billion of their overall AUM as of 2023. 

Yao discussed AQR's investment philosophy and their approach to various strategies. AQR considers itself a fundamental investor using systematic tools to exploit market inefficiencies. Yao emphasized the importance of understanding behavioural biases and structural reasons behind these inefficiencies.

Trend following, value, carry, and other risk premia strategies exhibit cycles, and Yao suggested that it is important to study these cycles to understand the nature of underperformance. He highlighted AQR's research into trend following, which revealed that low macroeconomic volatility led to fewer large market moves, negatively impacting trend following performance.

Regarding the dual mandate of delivering high absolute returns and crisis alpha, Yao shared that AQR aims to maintain the convex payoff profile of traditional price trend strategies while selectively adding other types of return streams. They have excluded certain strategies, such as currency carry, which tend to suffer during periods of equity market stress. AQR has incorporated economic trend following and alternative market trend following to improve the Sharpe ratio of their trend strategies.

The Importance of Portfolio Sharpe and the Need to Apply a Consistent Allocation Towards Trend Following

Niels and Yao discussed the challenges of trend following strategies and the importance of considering Sharpe ratios in a portfolio context. 

Yao highlighted that despite the significant benefits trend following can provide to a portfolio, many institutional investors still focus on line-item performance due to organizational structure and benchmarking requirements. They acknowledged the difficulties in educating investors to take a more holistic view of the value of trend following.

Yao also addressed investors' tendency to try and time trend following allocations, pointing out that there's no empirical evidence to support timing success. Instead, he suggested that trend following should be treated more like equity markets, with a consistent allocation rather than attempting to time the market. By reframing the strategy in this way, Yao hopes to persuade investors to see the long-term benefits of trend following in their portfolios.

Timing trend following allocations refers to investors attempting to adjust their allocations to trend following strategies based on their expectations of future performance. The idea is to increase the allocation when the strategy is expected to perform well and reduce it when the strategy is expected to underperform. However, there are several concerns with this approach:

1. Lack of predictability: Trend following strategies are inherently based on price trends and momentum, which are difficult to predict. Historical data has shown that there is no strong relationship between the past performance of trend following strategies and their future returns. Thus, trying to time allocations based on recent performance may not be a reliable strategy.
2. Absence of fundamental metrics: Unlike traditional asset classes like equities or bonds, trend following strategies do not have any underlying valuation metrics, such as price-to-earnings ratios or bond yields, to help guide investment decisions. This makes it even more challenging to time allocations effectively.
3. Potential for missed opportunities: By trying to time trend following allocations, investors run the risk of being under allocated when the strategy performs well and overallocated when it underperforms. This could lead to suboptimal portfolio performance and missed diversification benefits that trend following strategies can offer.
4. Market timing difficulties: Market timing is generally considered to be a challenging endeavour for any investment strategy, as accurately predicting market movements is notoriously difficult. This applies to trend following strategies as well. Investors who try to time their allocations may end up making poor decisions based on market noise, emotions, or biases, which could hurt their overall portfolio performance.
5. Overemphasis on short-term performance: Focusing on timing trend following allocations can lead investors to pay too much attention to short-term performance, at the expense of long-term benefits. Trend following strategies can provide significant diversification and risk management advantages over the long term, which may be diminished if investors constantly adjust their allocations based on short-term performance swings.

Instead of trying to time trend following allocations, investors should consider maintaining a consistent allocation to the strategy as part of a well-diversified portfolio. This approach can help capture the long-term benefits of trend following while minimizing the risks associated with market timing.

A Fundamental Approach to Trend Following: Economic Trend Following

Yao discussed the departure from the conventional trend following approach by incorporating economic trend following. This method, while not purist, is still considered part of the same family of investment strategies due to the shared underlying premise of underreaction. Both price trend following and economic trend following are seen as having similar long-term efficacy in predicting market trends.

Economic trend following requires more complex mapping between economic data and asset class performance. This approach is not expected to always outperform price trend following, but it provides diversification benefits when combined with price trend following. Confidence in the efficacy of economic trend following comes from extensive empirical research, testing in various markets, and the consistency of observed patterns over time.

Niels raised concerns about economic trend following, such as unexpected equity performance in response to economic data, and the fall of systematic global macro strategies. Yao acknowledged these points and emphasizes that both price and economic trend following have their merits and should be considered complementary, with the benefits of diversification and multiple perspectives on market trends.

A Half Century of Macro Momentum 

Yao mentioned that AQR published a paper on economic trend following called "A Half Century of Macro Momentum," which examines the strategy applied over the last 50 years. AQR is planning to release another paper in the next few months, focusing on economic trend following as a standalone strategy, looking at its history, robustness, and relationship to price trend following.

Alan commented on the fact that simple economic analyses, such as better economies benefiting stocks or lower inflation benefiting bonds, still seem to be persistent and valid despite being well-known. 

Yao acknowledged the similarities between price trend following and economic trend following, stating that both strategies continue to work due to behavioural biases and slow adjustments to new information in asset prices. Additionally, economic data tends to be autocorrelated, with forecasters and central banks gradually adapting their expectations and actions, which also contributes to trends in the data.

From Quant Macro to Trend Following

Yao explained that AQR initially traded economic trend following strategies as part of their quant macro hedge funds without recognizing them as trend strategies. Over time, they noticed similarities between the return characteristics of economic trends and price trends and started to connect them. Economic trend following has a correlation of 0.4 to 0.5 with price trends, making them related but distinct strategies. Combining the two strategies helps AQR to better predict market movements.

AQR aims to bring their research into the academic space. When Yao co-wrote the first paper on time series momentum, there were few academic papers on the topic. Since then, it has become a well-known academic style with many papers published on it.

Regarding overreaction in futures markets, Yao sayed that mean reversion and valuation metrics are more useful in a relative value context, comparing one equity index to another or one bond market to another. While these metrics are used in AQR's relative value global macro strategies, long-term mean reversion strategies are found to be less profitable in directional macro or trend-based strategies.

Capacity, Fees and Flows

Yao acknowledged that AQR's flat fee approach to trend following might have created an impression that the strategy is easy and inexpensive to execute, but running real-life strategies involves various challenges such as implementation, risk management, data, and systems. The intention behind demystifying trend following and providing academic evidence is not to devalue the strategy but to provide a better understanding and encourage broader adoption.

Yao believes that making trend following more widely adopted due to the strong academic evidence can be beneficial, despite potential misinterpretations about its ease of execution. Allocators who invest in trend following will eventually realize that there is a wide dispersion among managers, showing that it's not a simple beta strategy.

As for capacity, Yao did not provide a specific answer but emphasizes the importance of practical implementation and generating profits in markets, which is never easy.

Niels asked Yao about the capacity limits in trend following strategies and if there is a limit to how much firms can manage without impacting performance. Yao acknowledged that there are capacity limits for all strategies, including trend, but these limits are more of a function of the size of the underlying market. For liquid markets like US Treasuries and major stock indices, the trend following industry has not come close to being too big to impact performance. However, capacity considerations become more significant in smaller, less liquid markets like alternative markets.

Yao emphasized that capacity is always a concern, as any good strategy with too much capital behind it will find it harder to generate returns going forward. Nevertheless, he believes that large managers do not consider themselves close to closing their funds in liquid markets, as there is a significant difference in capacity depending on the size of the underlying markets.

Liquidity and Diversification

Yao explained that the daily liquidity of some trend following strategies is due to the accessibility and convenience of certain investment structures, such as mutual funds and ETFs. The goal is not for investors to trade in and out daily but to make managed futures more accessible to a wider range of investors.

As for the importance of portfolio construction in trend following strategies, Yao acknowledged that diversification and risk management are crucial. Better models for forecasting correlations and volatilities can improve a strategy's return stream. However, there is often a lack of appreciation for these aspects, and some investors might not understand the importance of adaptability to changing market conditions and the sophistication of risk forecasting models in generating better returns.

Trend Replication

Alan asked Yao about the merits and pitfalls of trend replication in the mutual fund world. Yao explained that there are different approaches to replication, such as using a small set of liquid futures to approximate the positioning of an index or mimicking the statistical properties of a strategy. Replication works well if major trends occur in the large markets, but discrepancies may arise if trends occur in a more diverse set of markets not represented in the replication set of futures.

Yao prefers actually implementing the strategy rather than relying on regression-based replication. 

Niels questioned the risk management aspect of regression-based replication, and Yao agreed that running the underlying strategies allows for better risk control. Backward-looking replication may struggle to adapt to abrupt shifts in trends or risk-taking levels, resulting in potential tracking errors between the actual strategy and the replication.

Trend Following as Part of a Broader Portfolio

Alan asked Yao about the role of trend following in a diverse portfolio, particularly when compared to other alternative strategies. Yao explained that trend following is an important component due to its diversification benefits and its convexity profile, which is unique compared to other alternative strategies like equity market neutral or arbitrage strategies. Trend following has become more prominent in AQR's multi-strategy portfolios over the last 25 years due to these attractive characteristics.

The value of other alternative strategies depends on the investor's objectives. In multi-strategy hedge funds where trend following is only a part, the convexity profile will be less pronounced than in a pure diversified trend following offering. AQR's multi-strategy funds are more tilted towards higher Sharpe ratios and less towards the convex profile, whereas trend following strategies strike a balance between the two, with a slight tilt towards higher convexity.

Misconceptions about Trend Following

Niels asked Yao about the one thing he hears about trend following that he disagrees with the most. 

Yao sayed that people often have a sense that trend following is easy to time, which undermines its usefulness within a portfolio. He pointed out that some investors decide to enter or exit trend following based on their perception of market conditions or volatility levels, but this approach is not helpful. 

Yao emphasized that it's important to view trend following as a strategic allocation rather than a trade to achieve better outcomes.

Outlook for 2023

Yao sharese that he is excited about the increased recognition of the importance of diversification beyond stocks and bonds. 

The year 2022 served as a wake-up call for many investors, who are now seeking additional tools to diversify their portfolios. Trend following is a significant part of the solution, and AQR offers multiple strategies that address this need. 

Yao finds it exciting to reengage with investors and delve deeper into portfolio diversification questions, particularly in the context of high inflation and potential equity market challenges.

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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.