Risk Parity Resources: Hurst et al. (2017) "A Century of Evidence on Trend-Following Investing"

Reconstructed data to test how a momentum strategy would have done since 1880. Authors find robust performance, with  added bonus of basically no correlation to stocks & bonds, and positive performance in a variety of economic regimes. Strong support for including managed futures in an RP portfolio.

Read the original:

A Century of Evidence on Trend-Following Investing
We simulate a trend-following strategy back to 1880 and investigate whether strong performance over a few decades was a statistical fluke, or a more robust phenomenon that may hold true over a wide range of economic conditions.

"Trend-following investing has performed well in each decade for more than a century… We find that a trend-following strategy performed relatively similarly across a variety of economic environments and provided significant diversification benefits to a traditional allocation." - Hurst, Yao, and Pedersen (2017)

I’ve been giving strong consideration lately to adding a new asset class into mix for a Risk Parity portfolio, in keeping with the pursuit of the “holy grail” for investing: creating a portfolio that combines multiple, uncorrelated asset streams each with a  positive expected return. In case you missed it, here is a primer on managed futures:

Managed Futures: A Primer
This trading strategy, that goes long or short on futures contracts for a variety of assets depending on their momentum, has some promise as a unique, uncorrelated asset stream with a positive expected return. Here’s a primer that considers whether managed futures have a place in RP portfolios.

… and here is a closer look at a specific asset that makes this approach available (at a reasonable cost) to the DIY investor: DBi Managed Futures ETF (DBMF)

Preferred Asset for Managed Futures: DBMF
If managed futures are going to be included in a RP portfolio, what’s the best asset? My vote is for DBMF, which has had solid returns and low correlation to stocks and bonds in its short history. Proceed with caution for this asset though, because of that very short history.

I wanted to take a closer look at the evidence behind managed futures, and came across this paper (thanks Connor, for the tip!), going over how a basic version of the strategy would have performed in the long run. Always a sucker for century-long data sets, I couldn’t resist this one where researchers at AQR managed to re-assemble commodity, equity, fixed income and currency data back to 1880 in order to test how a time-series momentum strategy would have done.

Brief word: while at an expert level, “managed futures” and “time-series momentum” would have key differences, they are, for my purposes, pretty much the same thing. You go long on futures contracts that are showing a positive trend, and you short contracts that are displaying negative momentum.

Important Points for the RP Investor:

In all, the authors find great support for a managed futures strategy in a portfolio. Let’s break down the paper:

Page 1: observation that managed futures has performed well in the years before publication (2016), but there wasn’t much data stretching back farther to test if this was just a fluke.

Page 2: Methodology for reconstructing the data to allow testing back to 1880. In short - they cracked open a lot of dusty old almanacs of the Chicago Board of Trade

Pages 2-4: Performance over a century. Presentation of results, highlighted by exhibit A which shows decade-by-decade results, plus these cumulative results:

Hurst, Yao, and Pedersen (2017), Exhibit 1, page 3

Pages 4-6: Performance during crisis periods. Next, the authors take on the question of whether the strategy works best in eighth bull or bear markets. They note a “smile” pattern as the strategy has done best in times of strong trends when bull or bear markets are the strongest; when the strategy has not done as well is when US equity markets are in the middle, or near their historical averages in the high single digits.

Hurst, Yao, and Pedersen (2017), page 6

Pages 6-10: Performance across economic environments. Key section here for Risk Parity aficionados, as the authors test momentum’s performance in different economic “seasons.” In fact, they specifically address its performance in different growth regimes and different inflation regimes, harkening back to Dalio’s four-box schematic that is at the heart of the RP approach. They find that positive, consistent performance across the board.

Pages 10-11: Conclusion. Support for managed futures as an asset class, one with positive expected return  and one with volatility uncorrelated with stocks and bonds.

My look into managed futures began with a query: managed futures seemed promising as an asset class getting investors closer to Ray Dalio’s “holy grail” of a portfolio with 15 uncorrelated asset streams, but should they be a part of my RP portfolio?. Based on my look into managed futures more generally, then a specific investigation of an ETF, and now this look at 136 years of historical data, it's pretty clear that managed futures have passed the test. I’ll continue to monitor them in my test portfolios, and soon start investing in them in real life, as well.

Other Resources Related to this Paper:

The lead author, Brian Hurst, was a Principal at AQR up until 2020, and is now at something called “Stealth Mode Fintech Startup,” or at least, that’s what LinkedIn says. I then tried to do some more digging, and it appears that a “stealth mode fintech startup,” is probably more likely a type of startup company that wants to keep its activities secret,  rather than a name of a particular firm. Kind of a fascinating article on this here. It all sounds pretty secret agent-y.