For financial advisers and professional investors only – not for distribution to retail investors.
April 2024
This article has been written by Winton
The Winton Global Alpha Fund is proudly brought to you by Macquarie Professional Series.
If you only have one minute…
- In recent months, benchmark cocoa futures have surged. Due to bad weather, bean disease, and a lack of investment in new trees stretching back decades, recent cocoa harvests have been poor, resulting in a yawning gap between supply and demand.
- Cocoa is the top-performing exposure year-to-date (as at May 2024) in the Winton Global Alpha Fund, the first time the market has been a notable source of profits since 2002.
- This highlights the importance of diversification in trend following – Winton believes that by casting a wide net and combining as many diversifying exposures in a portfolio as possible, a manager can aggregate the small investment edge of trend following in each individual market.
Having generated sizeable profits over the course of 2023, cocoa is the top-performing exposure year-to-date (as at May 2024) in the Winton Global Alpha Fund. Prices more than doubled from the beginning of the year through to mid-April, before reversing sharply amid elevated volatility. By this point, the fund had reduced its position considerably, effectively locking in-profits from this price trend.
That said, seeing a relatively small market have such a large impact on performance is rare. Just as rare – at least in Winton’s 26-year history – is seeing trend following make money in cocoa. The last time the market was a notable source of profits for the strategy was 2002, and this is regardless of the speed of models used.
New York cocoa: Cumulative back-adjusted futures return since 2000
Source: Winton, Bloomberg, as at 31 March 2024.
The conclusion one might reach looking at the previous chart prior to 2022 is that trend following has stopped working in cocoa. And, at that time, it would have been reasonable to ask why we trade a market that has continuously lost money.
The answer to this question is rooted in the limitations of trend following. The strategy only has a small edge in each market on average, which means that at the market level, multi-year drawdowns are highly likely. Moreover, we are yet to find a way to predict – with any statistical confidence – when and in which markets the next profitable trends will emerge.
Diversification through trading universe
The best way to counter these limitations is to cast a wide net and to combine as many diversifying exposures in a portfolio as possible.
We illustrate the benefits of diversification in the following analysis, which shows the range of simulated 10-year Sharpe ratios (y-axis) for different sizes of trading universe (x-axis). To visualise the range of outcomes, we select at random up to 100,000 combinations of markets for each size of trading universe.
Market diversification in action: gross hypothetical 10-year Sharpe ratios for a number of markets traded
120 major markets
240 major, alternative and Chinese markets
Source: Winton, as at 31 March 2024. The above results are based on hypothetical strategies shown for research purposes only. They do not reflect actual trading results and are not representative of a strategy or investment product. Hypothetical performance has inherent limitations, some of which are disclosed in the Important Information at the end of this document.
In the left plot, we constrain ourselves to selecting universes from 120 major markets: those futures and OTC FX exposures that have been traded widely by CTAs for decades. The median Sharpe ratio shows how the benefit of every new market added to the universe diminishes and almost flatlines from about 70 markets traded onwards.
Some CTA managers use this observation to explain why they trade a smaller number of markets. But how do they know ex ante that they have picked the right 70 markets? The difference in Sharpe ratio between the best and worst 70-market portfolios over the past 10 years is approximately 0.8.
In the right plot, we take this analysis one step further. We look beyond the traditional 120 CTA markets and include another 120 alternative and Chinese futures markets. These markets are harder to access for CTAs due to either off-exchange trading, the requirement of bespoke regulatory approvals or the involvement of non-standard trading and settlement procedures.
In our case, the additional 120 markets have been selected carefully to ensure that they are diversifying for the original universe. This means that there are no interest rate swaps on exposures for which there is a comparable future, no equity sectors, and an emphasis on novel commodities.
Followers of the CTA industry will know that trend following on alternative markets and Chinese markets has produced a higher Sharpe ratio over the past decade. However, assuming that these markets produce the same level of returns on average as the traditional CTA markets seems prudent now that they are traded more widely.
Even after penalising the returns of the new markets, the right chart above shows how the improved diversification from the additional markets shifts the range of 10-year Sharpe ratios higher.
Diversification through trading signals
The other way we can improve diversification within the portfolio is by incorporating trading signals other than trend following. In particular, we focus on finding complementary signals that can add value at times when trend following struggles, such as during range-bound environments or around reversals.
Cocoa is a good example of this. Apart from during the recent uptrend and in the early 2000s, trend following has struggled. However, by combining the trend-following strategy with smaller allocations to diversifying signals, we can improve overall results, while still participating in the major trends.
At times, these non-trend signals may hold similar positions to trend following – as is the case with cocoa now – but over the long term they should improve our edge in a given market. In cocoa, much of this edge in the past appears to have come from positioning for trends earlier than the trend-following strategy, which we see below in 2022, in 2016 and in 2008.
Conclusion
This highlights the importance of diversification for trend followers, both in terms of markets traded, and the inclusion of signals complementary to trend. Winton believes that by casting a wide net and combining as many diversifying exposures in a portfolio as possible, a manager can aggregate the small investment edge of trend following in each individual market to produce better outcomes for investors.
Information on hypothetical performance
This document contains simulated or hypothetical performance results. Hypothetical performance results have many inherent limitations, some of which are described below. No representation is being made that any account will or is likely to achieve profits or losses similar to those shown. In fact, there are frequently sharp differences between hypothetical performance results and the actual results subsequently achieved by any particular trading program. One of the limitations of hypothetical performance results is that they are generally prepared with the benefit of hindsight. In addition, hypothetical trading does not involve financial risk, and no hypothetical trading record can completely account for the impact of financial risk in actual trading. For example, the ability to withstand losses or to adhere to a particular trading program in spite of trading losses are material points which can also adversely affect actual trading results. There are numerous other factors related to the markets in general or to the implementation of any specific trading program which cannot be fully accounted for in the preparation of hypothetical performance results and all of which can adversely affect actual trading results.
The Winton Global Alpha Fund is designed for consumers who:
- are seeking capital growth
- are intending to use the Fund as a minor allocation or satellite allocation within a portfolio
- have a minimum investment timeframe of five years
- have a high or very high risk/return profile for that portion of their investment portfolio, and
- require the ability to have access to capital within one week of request.
Important information: The Target Market Determination (TMD), available at macquarie.com/mam/tmd, includes a description of the class of consumers for whom the Fund is likely to be consistent with their objectives, financial situation and needs.
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The Fund(s) mentioned above may have multiple classes of units on issue. A separate class of units is not a separate managed investment scheme.
This information has been prepared by Macquarie Investment Management Australia Limited (ABN 55 092 552 611 AFSL 238321) the issuer and responsible entity of the Fund(s) referred to above. This is general information only and does not take account of investment objectives, financial situation or needs of any person and before acting on this information, you should consider whether this information is appropriate for you. In deciding whether to acquire or continue to hold an investment in a Fund, an investor should consider the product disclosure statement for the relevant class of units in a Fund, if any, and the Website Disclosure Information available at macquarie.com/mam or by contacting us on 1800 814 523.
Nothing in this document constitutes a recommendation to buy, sell or hold any financial product, security or instrument.
Future results are impossible to predict. This document contains opinions, conclusions, estimates and other forward-looking statements which are, by their very nature, subject to various risks and uncertainties. Actual events or results may differ materially, positively or negatively, from those reflected or contemplated in such forward-looking statements.
Past performance information shown herein, is not a reliable indicator of future performance. No representation or warranty, express or implied, is made as to the suitability, accuracy, currency or completeness of the information, opinions and conclusions contained in this document. In preparing this document, reliance has been placed, without independent verification, on the accuracy and completeness of information available from external sources. To the maximum extent permitted by law, no member of the Macquarie Group nor its directors, employees or agents accept any liability for any loss arising from the use of this document, its contents or otherwise arising in connection with it.