Past performance should not be used as a guide to future performance, or so we are frequently told. However, the analysis of past markets is often integral to our overall understanding of market behaviour. This is particularly prevalent for systematic approaches, which analyse vast amounts of market data in order to benefit from what has worked previously. Such approaches have been successful in the past, as evidenced by the track records of various systematic investment strategies. Yet 2018 has been far more challenging; the CTA sector recorded its worst ever month of performance in February of this year. So why has this been the case?
2018 has been a year of idiosyncratic market moments. On one hand, the global economy has been progressing well and corporate earnings have largely continued to improve – suggesting that the positive, risk-on sentiment among investors would continue. Yet such an apparently benign environment has been plagued by a series of headwinds: the threat of inflation resurfacing; rising trade tensions stemming from President Trump’s aggressive trade rhetoric; and a series of disruptive events across emerging markets. Added to this is the notion that the world economy, or notably its key economic engine the US, is peaking in terms of both growth and earnings combined with a belief that we are in the middle of an “interest rate normalisation” cycle. These contradictory market narratives have led to a series of month by month convolutions that have resulted in many markets having very little predictability or consistent direction throughout the year.
Periods of such inconsistency, and irrational investor behaviour, can be difficult for anyone to interpret and consistently get right from an investment perspective; computer-driven trading programs are no different. Sophisticated statistical analysis seeks to interpret a vast array of data sources in order to better understand what has worked well in the past and therefore tilt portfolio focus to suit present market conditions. But when a market adjustment happens very rapidly, with little or no forewarning in terms of changing market fundamentals – as happened in both February and October of this year – there are often no indicators which forecast these changes.
While it is of little consolation to those who have experienced losses, we take some assurance from the fact that our models behaved exactly the way we would have expected them to during these periods of market turbulence. Our models are based on data gathered from all market environments since 1980 and have been through difficult periods both in simulation and in real world conditions. No investment process – discretionary or systematic – can be expected to work in every situation. Moreover, in environments such as this, we believe there is considerable danger in trying to overfit the investment process to recent regimes which are unlikely to persist throughout the future. To us, when conditions go awry, it is a time to try and understand whether the ground rules have changed, to focus on research, and if we deem it appropriate, to seek to find incremental and marginal improvements.
When considering any market environment, we believe it is important to establish the extent to which the market behaviour is part of a pattern or a one-off anomaly. 2018 is no different here. We have asked ourselves the question of whether we are in a permanent change of environment and therefore whether we should be optimising our models to fit to this. While many markets have experienced sudden spikes in investors’ attitude to risk, we do not believe this fundamentally changes how investment markets will behave over the long term. To us, there is no evidence markets will be permanently changed by the events of 2018, rather that there are some indications we are nearing the end of a cycle. We acknowledge that it can be hard for models (and people) to latch on to the rapid market movements that often occur during such an end of cycle regime shift, but we do not believe this should necessitate an adjustment to these models.
Looking ahead, it seems reasonable to expect to see equity markets return to higher volatility levels while delivering lower overall returns, particularly as equities have experienced a period of very low volatility and very high returns since the financial crisis in 2008. So while it has been a very challenging year for systematic strategies overall, we firmly believe that investors seeking a reasonable return stream in the future should consider incorporating dynamic, reactive strategies that have the ability to generate uncorrelated sources of return into their broader portfolios. Systematic strategies have demonstrated in the past their ability to deliver such returns and we feel confident in their ability to continue to behave in a robust manner in most market conditions.