Are trend-following strategies well-suited to future inflationary environments?
Are trend-following strategies well-suited to future inflationary environments?
June 2021
Over the past 40 years, trend-following investors have scant evidence for the effect that inflationary regimes might have on their strategy.
Introduction
Quantitative trend-following strategies have been in existence for around 40 years. Over this period, we have experienced only two bursts of inflation. As a result, trend-following investors have scant evidence for the effect that inflationary regimes might have on their strategy.
At the time of writing, inflation remains low but is showing signs of ticking higher. Much of this fear can be seen in the increase in the US 5-year, 5-year forward inflation expectation rate, from a low of 0.86% in February 2020 to above 2.25% in April 2021 (Figure 1). The goal of this article is not to predict the direction of inflation, but rather to analyse the impact of higher inflationary regimes on the performance of the trend-following industry. We do this by examining academic studies covering historic periods of high inflation, as well as performance of the Barclay BTOP50 (‘BTOP50’) Index of trend-following managers over two of the most recent inflationary regimes.
Figure 1. US 5-year, 5-year Forward Inflation Expectation Rate
Source: Man Group, Bloomberg; as of 30 April 2021.
Through the Lens of History
For much of this article, we will rely on the data produced by our colleagues in their recent academic paper ‘The Best Strategies for Inflationary Times’ by Neville et al. They define inflationary regimes as the times when the headline, year-on-year inflation is accelerating, and when the level moves to 5% or more. The eight inflation regimes that they identified are shaded grey in Figure 2. They argue that rising inflation rate episodes are mostly caused by unexpected inflation shocks, and assets may reprice materially during such rising inflation regimes. To assemble a critical mass of evidence, Neville et al. used data from 1926 across three continents.
Figure 2. US YoY CPI Overlaid With Inflation Regimes
Source: H. Neville, T. Draaisma, B. Funnell, C. Harvey & O. Van Hemert, The Best Strategies for Inflationary Times; 1926 – March 2021.
Note: The % increase in the US headline Consumer Price Index (‘CPI’) basket over the trailing 12-month period. The grey shaded areas demarcate quantitatively defined inflation regimes described briefly above. The rectangles at the bottom of the chart are periods where the US economy was in recession as defined by the National Bureau of Economic Research.
Figure 3 summarises the main findings from the paper for the US. We examine various real returns for a set of markets that likely would be represented in traditional trend-following strategies during the eight inflationary regimes (the grey shaded zones in Figure 2). Real returns are used throughout due to the degree that inflation has made a material impact on the purchasing power of USD1 over the long run.
While bonds and equities have historically struggled during inflationary periods, commodities have tended to perform strongly.
Unsurprisingly, weak returns are observed for nominal bonds, as rising inflation is typically associated with rising yields, and so declining bond prices. Perhaps more notable is that equities also perform poorly, compounding the challenge of the 60/40 equity/bond investor. The best historical performance is observed for commodities. In fact, commodities show much higher real returns during rising inflation environments than at other times.
One aspect that does stand out during these inflationary times (which represent 19% of the months going back to 1926) are the challenges faced by long-only investors in stocks and bonds — typically the bulwark of any investor’s portfolio. Both equities and government bonds are only profitable in two of the eight inflationary regimes. Unsurprisingly, the equity-dominated 60/40 approach fares similarly, with success in only two of the eight periods. We also note the contrast between the average success of a 60/40 portfolio in non-inflationary times (+8% annualised real return) with its struggles in inflationary times (-6% real return). Clearly, consideration is warranted to broaden the investment toolkit during times of inflation.1
Figure 3. Summary Performance in US Inflation Regimes
Source: H. Neville, T. Draaisma, B. Funnell, C. Harvey & O. Van Hemert, The Best Strategies for Inflationary Times; as of April 2021.
If markets do tend to exhibit the ability to make relatively large moves in inflationary periods, perhaps investigation of more active investment strategies could be useful. In particular, trend-following appears well-suited to environments where markets are moving strongly either higher or lower.
So, how has inflation impacted trend-following performance looking back through history?
Trend-Following in Inflationary Periods
Neville et al. created a trend-following approach applied to liquid futures and forwards (or proxies). They followed the methodology of Hammill, Rattray and Van Hemert (2016) and Harvey, Rattray and Van Hemert (2021). The strategy has a 10% ex-ante annualised volatility target and the weights to historical lags in the trend definition were chosen such that it best approximates the returns of the popular, trend-following BTOP50 Index.
Generally, equities data for major markets began in 1926 and other markets entered as they became available. Within fixed income, US bonds data is available since 1926 and most European bonds are included after 1950. For commodities, soybeans, corn and wheat data began between 1940 and 1950, while FX starts after the end of Bretton Woods in 1973. Transaction costs of 0.8% are assumed.
Figure 4 displays the results of this trend-following strategy. Perhaps not surprisingly given the pronounced market moves during inflationary times, the trend-following strategy sees positive real returns across all four asset classes as well as the ‘all-asset trend’ version in each of the individual inflationary regimes. Due to the notion that bonds and commodities have a very clear exposure to inflation (suffering and benefiting from rising inflation, respectively), these results seem intuitive.
Figure 4. Trend Strategies in Inflationary Regimes
Source: H. Neville, T. Draaisma, B. Funnell, C. Harvey & O. Van Hemert, The Best Strategies for Inflationary Times; as of April 2021.
The above results should be considered hypothetical Simulated performance data and hypothetical results are shown for illustrative purposes only, do not reflect actual trading results, have inherent limitations and should not be relied upon. Please see the end of this material for additional important information on hypothetical results.
The large moves posted by assets in inflationary time seems particularly well suited for a trend-following approach.
What becomes very clear is the efficacy this trend strategy displays in times of inflation. Not only is it positive in all of the historical inflation periods, it has generated a 25% annualised real return versus a 15% return in all other months. The large moves posted by assets in inflationary times seem particularly well suited for a trend-following approach to capture.
Trend-Following in Inflationary Periods Using a Live Track Record
The academic study by Neville et al. outlined above opens up a wide range of insights on inflation, driven in part by their diligence in sourcing data going back to 1926. This has widened the analysis to include past periods of inflation that were previously challenging to evaluate using more conventional data.
Neville et al.’s results with their proxy BTOP50 trend-following strategy are encouraging, but we can examine the effects of two inflationary periods on the BTOP50 itself since its inception in 1987. Importantly, the BTOP50 dates back to January 1987, which covers two inflationary periods identified by Neville et al.: ‘Reagan’s boom’ (February 1987 – November 1990) and the ‘China demand boom’ (September 2007 – July 2008). Using the BTOP50 as a proxy for trend-following programs, we can examine actual track records showing how trend-followers have performed in past inflationary environments, which might potentially give us insight into how trend-following programs might react during periods of future inflation.
Figure 5 shows the cumulative returns of the BTOP50 index since inception. Performance during the two inflationary periods are highlighted as well. Returns were solidly positive for the index during both periods. In ‘Reagan’s boom’, the index made a cumulative real return of 63% during the 46-month stretch. This equates to an annualised return of 14%. During the ‘China demand boom’, the index posted a real return of 7% over the 11-month timeframe, or 8% annualised.
Figure 5. BTOP50 Real Returns Since Inception
Source: BarclayHedge and H. Neville, T. Draaisma, B. Funnell, C. Harvey & O. Van Hemert, The Best Strategies for Inflationary Times, April 2021. Cumulative return of the BTOP50 Index from inception in January 1987 to February 2021. Periods of inflation as denoted by Neville et al. are highlighted in grey.
While the data might be limited, it is encouraging to see that performance was squarely positive for these inflationary regimes. It is also encouraging to see that the live real return results of the BTOP50 for the final two inflationary periods reasonably closely match the Neville et al. ‘all-asset trend’ real returns for those two periods.
Another way to look at the data is to examine the average monthly performance during the inflationary periods versus the non-inflationary periods (Figure 6). It is clear that this index of trend-followers outperformed during periods of inflation. Of course, there is no guarantee that these results will be duplicated in future inflationary times, but we believe that the properties of trend-following programs should be well-placed to benefit in a high and rising inflationary environment.
Figure 6. Live BTOP50 Real Returns in Inflationary Regimes
Source: Barclay Hedge, US Bureau of Labor Statistics, and H. Neville, T. Draaisma, B. Funnell, C. Harvey & O. Van Hemert, The Best Strategies for Inflationary Times; as of April 2021.
Results from academic studies and live the BTOP50 track record show that trend following works during non-inflationary regimes, but is particularly robust in inflationary ones.
Summary
Results from both the academic study and the BTOP50 track record since its inception in 1987 show that trend-following not only works during non-inflationary regimes, but is particularly robust in inflationary ones. This could be because we see strong trends during those periods: equities down; bonds down; and commodities up.
In our view, this does give reason to be optimistic that trend-followers are likely to be well-suited to future inflationary environments.
References
C. Hammill, S. Rattray, O. Van Hemert, Trend Following: Equity and Bond Crisis Alpha, August 2016.
C. Harvey, S. Rattray, O. Van Hemert, Strategic Risk Management – Designing Portfolios and Managing Risk.
H. Neville, T. Draaisma, B. Funnell, C. Harvey and O. Van Hemert, The Best Strategies for Inflationary Times, April, 2021.
1. For US equities, we use Robert Shiller’s data for the S&P 500 total return history. For US 10-year Treasury bonds, we use Global Financial Data’s total return index. The 60/40 portfolio consists of a 60% S&P 500 and 40% US 10-year Treasury bond investment (capital weighted), rebalanced monthly. All returns to equities and bonds are assumed to be physical, cash-settled transactions. Data for US Treasury nominal bonds are from Global Financial Data. Commodity price performance is derived from frontend futures contracts taken from the Man AHL database, while trend following performance is constructed from an in-house time-series momentum strategy applied to liquid futures and forwards (or proxies) across assets. All sector and style portfolios are from the Kenneth R. French database. All data is from 1926 to the present.
Hypothetical Results
Hypothetical Results are calculated in hindsight, invariably show positive rates of return, and are subject to various modelling assumptions, statistical variances and interpretational differences. No representation is made as to the reasonableness or accuracy of the calculations or assumptions made or that all assumptions used in achieving the results have been utilized equally or appropriately, or that other assumptions should not have been used or would have been more accurate or representative. Changes in the assumptions would have a material impact on the Hypothetical Results and other statistical information based on the Hypothetical Results.
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