Trend Following and Volatility Regimes - Graham …

1 Graham Capital ManagementResearch Note, October 2017 Trend Following and Volatility RegimesJack Fan1, Isaac Kleshchelski2 AbstractTrend- Following strategies can make money during large market price movements in either upward or downwarddirections. Because this resembles the payoff of an options straddle strategy, many investors are tempted to characterizetrend- Following as a long Volatility strategy. This short paper finds that, contrary to such an interpretation, Trend -followingcan perform well in both high and low Volatility environments. It is the existence of strong trends rather than highvolatility that preconditions good Trend - Following Following ; Volatility ; VIX1 Quantitative Research Manager2 Quantitative Research Analyst1. IntroductionTrend- Following can perform well when equities do not. Thisobservation has led investors to add Trend - Following products totheir otherwise equities-heavy asset allocation as a source of diver-sified alpha.

2 It may seem reasonable to consider Trend -followingas a long- Volatility strategy since Volatility tends to spike dur-ing periods of equity under-performance. Indeed, there is sometheoretical rationale that supports this interpretation. However,a more nuanced view suggests that this is not necessarily of Trend - Following returns and equity Volatility putsforward a relationship that is far from direct. As we will show, Trend - Following can perform well in both very high and very lowvolatility small thought experiment motivates this discussion. Imag-ine an asset that goes down 1% every day without fail. Anyreasonable implementation of Trend - Following would short thisasset and thereby make a certain gain with no Volatility on anasset that itself has no Volatility . So as this trivial example demon-strates, having zero- Volatility is not in itself a reason for badtrend- Following , consider another hypothetical asset whose dailyreturns are +5% followed by -5%.

3 This asset is all Volatility . Yet, Trend - Following on this asset would almost certainly yield as it is, this thought experiment suggests that it is notvolatilityper sethat matters to Trend - Following . Ultimately, Trend - Following strategies need strong trends to perform well. This canhappen in high or low Volatility sections that follow will briefly review the relationshipbetween Trend - Following returns and equity returns. The anal-ysis will then expand to include equity Volatility to show thattrend- Following can perform well in low as well as high Trend - Following as an Options StrategyFung and Hsieh (2001) considered Trend - Following to be a type ofoptions strategy where the investor simultaneously buys put andcall options on the underlying assets to profit from price trendingin both directions. As supporting evidence, they sorted monthlyreturns of the Morgan Stanley World Equity Index into average performance of large Trend - Following funds withinthe lowest and highest quintiles is higher than performance in themiddle ones.

4 This phenomenon, typically called theCTA smile,suggests to Fung and Hsieh (2001) that Trend - Following strategiesexhibit behavior that is similar to that of a straddle option smileis presented in a slightly different form inFigure 1. The monthly returns of the BarclayHedge CTA Index1is plotted on the y-axis against the contemporaneous S&P 500returns on the x-axis. Unsurprisingly, we see the same non-linearrelationship between equity and CTA returns that Fung and Hsieh(2001) saw. Trend - Following returns are high when equity returnsare very high and very 500 ReturnCTA Performance (%)QuintilelllllQ1Q2Q3Q4Q5 Figure Returns of CTA Index vs. S&P 500 mark the four quartiles of S&P 500 returns for ease BarclayHedge CTA Index is an equally weighted index of CTA fund re-turns. detailed documentation of the Following and Volatility Regimes 2/3lllllllllllllllllllllllllllllllllllll llllllllllllllllllllllllllllllllllllllll llllllllllllllllllllllllllllllllllllllll llllllllllllllllllllllllllllllllllllllll llllllllllllllllllllllllllllllllllllllll llllllllllllllllllllllllllllllllllllllll llllllllllllllllllllllllllllllllllllllll llllllllllllllllllllllllllllllllllllllll llllllllllll102030405060199020002010 DateVIXVIX Quartilell1st Quartile4th QuartileFigure of VIX Index with 1st and 4th quartiles is a strong resemblance between the smile shape inFigure 1 and the payoff of a long options straddle.

5 This inter-pretation in fact predates Fung and Hsieh (2001) all the way toMerton (1981). It is then only natural to reason that, since astraddle strategy benefits from high volatility2and is harmed bylow Volatility , then Trend - Following strategies would behave thesame , this reasoning is not necessarily correct. There is asubtlety that is worth pointing out: a strategy that resembles anoptions strategy does not necessarily mean that it is one. It maynot be exposure to Volatility that causes Trend - Following returnsvis-a-visequity returns to resemble a straddle strategy payoff. Analternative view is that Trend - Following requires strong moves tomake money. This can happen in both high and low volatilityenvironments, thus inducing theCTA becomes apparent when Trend - Following returns are com-pared against Volatility Regimes instead of equity Volatility RegimesIn this section, we will show that Trend - Following performancecan actually be quite positive in low Volatility environments.

6 Thisrejects the idea that Trend - Following as a strategy can only dowell in high Volatility times and supports our notion that it is thestrength of directional moves, rather than Volatility , that the spirit of theCTA smile, the BarclayHedge CTA Indexcontinues to serve as a proxy for Trend - Following performancewhile the VIX Index represents the market s expectation of near-term Volatility . The VIX index is an attractive option for thisanalysis as it is computed from options traded on the S&P 500 Index, which makes it analogous to theCTA long options straddle is a long Volatility strategy. As implied volatilityrises, both the long call and the long put gain in value. This is true regardless ofthe direction of the underlying market Volatility Regimes are derived from the four quartiles ofVIX Index levels. Figure 2 shows the history of the VIX Indexfrom January 1990 to June 2017.

7 The lowest and highest quartilelabels are shown on the figure as colored markers. Since volatilityis known to cluster, we see that the high Volatility quartiles formtwo distinct episodes: during 1997-2003 and then again from2008 to monthly returns of the Barclay Hedge CTAI ndex vs. VIX risk-adjusted average CTA performances in these fourVIX quartiles are computed and shown in Figure 3. Performanceis positive for all but the second VIX quartile. More strikingly,both the highest and lowest quartiles show better performancethan the middle fact that Trend - Following performs well in the highest VIXquartile is not terribly surprising. Since implied Volatility tendsto spike during equity crisis periods, the highest VIX quartile isassociated with the lowest equity performance quartile. As CTAperformance can be quite positive in such an environment, thisfact fits well with what is observed from theCTA Following and Volatility Regimes 3/3 Contrary to the interpretation of Trend - Following as a strategythat can only do well in high Volatility times, CTA performance isalso quite positive in the lowest VIX quartile.

8 Low Volatility , espe-cially in equities, does not imply a lack of trends . The experienceof the US equity markets in 2006 and early 2017 demonstratesthis well. Volatility , both implied and realized, were at are closeto all time lows while equity indexes trended strongly supports our contention that it is the existence of trendsrather than the existence of Volatility that dictates ConclusionTrend- Following strategies require strong directional moves inthe assets they trade to make money. If there are no trends tofollow and markets are rangebound, then the opportunities fortrend Following are more limited. The actual direction does notmatter as Trend -followers can short assets. Since equity marketscan sustain large negative trends in crisis times that benefit Trend - Following , the famedCTA smilecan be empirically observed inhistorical fact that Trend - Following can perform well in both verygood and very bad times means it resembles the payoff of anoptions straddle position.

9 This has led some investors to concludethat Trend - Following benefits from high Volatility and is harmedby low Volatility as would be the case for such an options paper the VIX Index as a measure of market Volatility , Trend - Following performance can be observed to be very positive inperiods of both very high and very low Volatility . This rejects theinterpretation that Trend - Following requires Volatility to , Trend - Following requires sustained market movementsthat can happen in both high and low Volatility Fung and D. A. Hsieh. The risk in hedge fund strategies:Theory and evidence from Trend Review ofFinancial Studies, 14(2):313, C. Merton. On market timing and investment performance i:An equilibrium theory of value for market Business, 54:363 407, 1981.