Trend-following hedge funds seem to be searching for a new investment strategy.

Trend-following seemed to be the strategy to follow when the Federal Reserve was constantly pumping money into the financial markets in a effort to keep the economy going and avoid any kind of a relapse back into a recession.

Robin Wigglesworth and Laurence Fletcher write in the Financial Times,

Although many hedge funds have been rattled this year, the performance of trend-followers is of particular importance.”

Since the financial crisis they have become popular among many pension funds, private banks and endowments as a kind of insurance policy against downturns—thanks to previous strong performances at times of turmoil, such as in 2008.”

Environment Since Great Recession

The Federal Reserve System has dominated the economic policy-making scene since the end of the Great Recession.

Fed Chairman Ben Bernanke set out to combat the recession of 2007-2009 with sufficient stimulus that there would be little or no chance for the United States economy to revert back into a recession.

Mr. Bernanke’s plan was to stimulate stock prices, creating a wealth effect in the economy that would spur on consumer spending and drive the economic recovery. Through three rounds of quantitative easing, followed by further efforts to keep the economy growing, the US stock market reached and then continued to hit new historic highs. Commodity prices also followed suit.

The efforts of Mr. Bernanke and the Fed were quite successful. Fed leadership under Fed Chairs Janet Yellen and Jerome Powell followed-up on the policy and the US economy continued to grow up till February 2020.

READ ALSO  Cleveland-Cliffs Inc. (CLF) CEO Lourenco Goncalves on Q3 2020 Results - Earnings Call Transcript

Under the consistent attempt to keep asset prices rising, investment strategies changed. Especially with stock prices rising year-after-year-after year during this time, investors came to appreciate the fact that the risk/return tradeoff for passive investment strategies tended to produce much better results than did more aggressive, value-oriented strategies.

Consequently, money moved more and more to the funds that were following passive strategies. This included what came to be called “trend-following” hedge funds

Policy Adjustment At The Fed

Jerome Powell became Chairman of the Board of Governors of the Federal Reserve System on February 5, 2018.

Mr. Powell’s first year in this office was relatively similar to what had preceded him, although things were beginning to change.

In 2019 real changes took place requiring the Federal Reserve to adjust to the developing events. Financial markets were becoming more volatile and Federal Reserve actions had to be clarified more often after actions were taken.

Investors had become very confident about Federal Reserve intentions following the Great Recession and “trust” was at a high level when Mr. Powell took over as Chair. But, the markets were becoming more nervous and Mr. Powell had to be more responsive to market concerns given the increasing volatility taking place.

Investors continued to “trust” and wanted the Fed to continue to support asset markets, but now required this “trust” to be reconfirmed if questions arose.

Volatility continued to increase during 2019, but sky-rocketed in 2020 as the effects of the coronavirus pandemic helped to shut-down the US economy and the economy moved into a recession in February.

READ ALSO  The Greenbrier Companies: A Mixed Hold Here (NYSE:GBX)

The Federal Reserve responded massively in March and April, both domestically and internationally, as it opened up many different avenues to provide liquidity to the banking system and the financial markets.

Performances Have Been All Over The Place

As a consequence, performances have dropped. Mr. Wigglesworth and Mr. Fletcher state that a major index of “quant” funds, funds that specialize in riding market trends, is down 2.2 percent for the year. This compares with an index of the hedge fund industry which has an average increase of 2.0 percent for the year.

The authors go on,

The disparity is partly explained by the swiftness and depth of the market drop and then recovery, as trend-followers naturally suffer to some degree in abrupt changes in market momentum.

There’s always some dispersion in the industry, but there’s certainly an unusual amount of it this year.”

Because of this some trend-followers have begun to reassess they core strategies and move toward a little less trend following.

Signal To Investors

In the past, I have suggested that investor’s watch what is happening in the world of hedge funds in order to see what kinds of strategies are working and which ones are not.

The performance of these trend-following hedge funds over the past 12- to 18-months raises the question about changing market patterns…patterns that are changing in a way the other investors might need to assess their own investment strategies.

Leda Braga, the head of Systematica, whose BlueTrend fund is up about 5 percent this years is quoted as saying that this year’s volatile conditions underscore the need to continually improve on trend-following systems rather than drifting too far from the core strategy.

READ ALSO  Alberta Set To Lift Mandatory Oil Production Cuts In December

Ms. Braga closes with,

We don’t claim to have found the Holy Grail. We have to continually learn and adapt our algorithms to cope better, enrich our models and prepare them for regime changes.”

This is advice that we all need to take to heart.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.