“In reality, as soon as you aggregate people around the decision-making process of any kind, they will ‘trend follow’. They are seeking the safety of the tribe.”
But what Jordan has come to appreciate is that the same psychology that he seeks to exploit in markets is one that he has to overcome when convincing investors they should allocate some of their funds to trend-following strategies.
Private equity is trending
Right now, trend-following strategies that involve buying what’s going up and selling what’s going down are a tough sell to investors.
That’s because the mainstream alternative of simply investing in the stockmarket has not only been profitable but relatively stress-free compared with other periods in history.
Over the past decade, the Sharpe Ratio (a measure of return per unit of risk) of equities has been 1.05, well above the longer-term average of 0.35
Meanwhile, trend-following strategies have delivered just 0.6, below their longer-term average.
“People are massively influenced by trends, and one of the biggest trends now is equity,” Jordan says.
An extension of that trend is allocating to private equity. It’s one that Jordan is observing with trepidation.
“Private equity is more volatile and the mere fact that you don’t compute the net asset value of the portfolio on a daily, weekly or monthly basis doesn’t make it less volatile,” he says.
Jordan says the correlation between equity and private equity is extremely high, as is the volatility of small and mid-cap stocks, which tends to be where private equity deploys its capital.
While trend-following strategies have disappointed, they have performed respectably over the decade. A dollar invested in the strategy has doubled over the period.
But timing was everything. The bulk of the gains came in one spectacular burst, during 2014 when the oil price tanked and bonds rallied relentlessly.
Many investors either lost patience by the time the pay off came, or got in too late and are still waiting to make money.
Trend-following paradoxically was a victim of its own success, Jordan admits. It delivered great numbers in the 1980s and 1990s, which allowed fund managers offering these strategies to charge exorbitant “2 and 20” performance and management fees.
But the combination of high fees and a reversion to more historic performances resulted in a poor outcome.
“That is the larger disappointment, It was massively oversold. Investors bought into that up fluctuation at hedge fund prices,” Jordan says.
Jordan cannot say when, but he is confident that at some point equities will revert to the long-term Sharpe Ratio of 0.35.
In other words, volatility will pick up or returns will fall.
If the stellar risk-adjusted performance of equities does continue well into the next decade Jordan says we will be entering a “regime of asset appreciation we have never seen before”.
“We are in the statistical business and it’s statistically unlikely to go a lot in that direction.”
While the decade -long rise in equities has helped sharemarket investors, some strategies have battled. So-called ”value” investors that have tried to identify undervalued stocks have lagged, while doomsday hedge funds that buy ”volatility” have eroded investor capital.
They have been on the wrong side of the easy money trade, which has calmed markets and paved the way for risky assets to run hard.
While most fund managers have lamented what they believe has been a dulling of market signals by accommodative central banks, Jordan actually launched a spirited defence of quantitative easing.
It is based on studying 200 years of market history and the devastating wealth destruction of deflation.
“The [policy] response [in 2008] was extraordinary, and extraordinarily successful in preventing economic deflation.”
He says the side effects of QE, such an increase in relative wealth inequality and the distortions and biases in markets, are an inexpensive price to pay.
Without the courage of central bankers, we would have had “true deflation, in equities, houses and salaries”.
“If you think of the politicians that we have today because of increased relative inequality, think of the politicians we would have had with true deflation.”
Jordan says CFM has performed well relative to the cohort of trend-following funds. The CFM ISTrend Class A and Class B fund (which targets a higher volatility) are up 7.2 and 10.1 per cent so far this year. Since inception in July 2017, the annualised returns are 1.3 per cent and 1.1 per cent.
The dispersal of returns among quantitative trend-following funds suggests that manager skill and process adds value to the strategy of buying what is going up and selling what is going down.
Jordan says CFM has added value via portfolio construction and its ability to diversify its exposures to trend.
He explains that quants use a process known as Principal Component Analysis (PCA) to determine what is driving a security price.
In the case of an individual stock, the overall direction of the stockmarket is usually the primary driver, then the overall direction of stocks in the industry, and so on.
In the case of main futures contracts, the PCA tends to be sentiment, whether there is a ”risk on” or ”risk off” tone. And while some investors may spread their bets over many futures contracts such as bonds, stocks and commodities, they actually tend to have a large concentration to market sentiment.
The objective of CFM is to make sure there is no overexposure to a single driver of trends such as risk sentiment and it will weight positions towards other factors such as the spread between oil and natural gas.
CFM, like other quantitative funds, knows it has to keep investing and innovating to remain competitive at a time when costs are falling and returns are harder to come by.
Jordan says every year, technology and quantitative strategies are changing the investment process.
Long gone are the days when brokers wore braces, smoked cigars and charged fat fees. And long gone are the days when technical analysts searched for patterns in charts painstakingly plotted with graph papers and pencils.
He’s a believer that the use of technology has “professionalised and increased the value of products people have access to”.
“What we do is not science, it’s a scientific approach,” says Jordan.
“It is a framework that seeks to be robust in handling information that is highly noisy, which is financial markets.”