Originally published on December 3, 2014
Trend Following with Managed Futures: The Search for Crisis Alpha (Wiley, 2014) by Alex Greyserman and Kathryn M. Kaminski is an academically rigorous book with a practical bent. Although on the surface it appears to have a narrow focus, in reality it covers a broad spectrum of important but often overlooked investing concepts. Even readers who have no real interest in managed futures can learn a great deal from it, especially if they have some familiarity with financial statistics.
The authors start with an 800-year historical perspective, and then discuss trend-following basics, theoretical foundations, trend-following as an alternative asset class, benchmarking and style analysis, and trend-following in an investment portfolio.
Here, I'll simply highlight a couple of ideas that are central to the book's thesis.
Let's start with the notion of crisis alpha. "Crisis alpha opportunities are profits that are gained by exploiting the persistent trends that occur across markets during times of crisis." (p. 145) Viewed in the context of the adaptive market hypothesis set forth by Andrew Lo in 2004, "for both behavioral and institutional reasons, market crisis represents a time when market participants become synchronized in their actions creating trends in markets. It is only the select (few) most adaptable market players who are able to take advantage of these 'crisis alpha' opportunities." (p. 73)
A key concept of the book is divergent risk-taking. "Convergent risk takers believe that the world is well structured, stable, and somewhat dependable. Divergent risk takers profess their own ignorance to the true structure of potential risks/benefits with some level of skepticism for what is or is not dependable." (p. 95) Investing in equity markets is a convergent risk-taking activity; investors "believe in both the existence of an equity risk premium over the long run driven by fundamental value and the efficiency of financial markets... In distribution, this is also true. Equity returns are positive in expectation, yet negatively skewed with fat left tails." By contrast, trend-following is an obvious financial example of divergent risk-taking. "Trend followers do not believe in anything but opportunity... When they see a trend they follow it, they give no consideration to fundamentals. In fact, the distribution of trend following is positive in expectation with positive skewness." (p. 97) That is, "Convergent trading systems generally focus on many smaller gains with the occasional extreme loss. Divergent trading approaches focus on smaller losses with the occasional extreme gains." (p. 98)
Using the market divergence index (MDI), "a simple aggregate measure of 'trendiness' in prices taking into account the level of volatility (or noise) in the price series" (p. 109), the authors show, using six agriculture markets with substantial price histories, that market divergence is stationary - that is, that "occasional 'trendiness' in markets is a stable characteristic of markets over the long run." (p. 115)
Some of the authors' findings are things we already believed to be true, but had no compelling grounds for believing. Their work provides us with the requisite quantitative underpinning.
For traders and investors who want to be challenged intellectually but not overwhelmed, this book is an illuminating read. And, let me repeat, it's not just for those who invest in managed futures.