The Hardest Trading Environment

Has 2018 actually been one of the most difficult trading environments one can encounter?

Of course a 50% equity decline in a severe bear market, as we saw in 2000 or 2008, for example, looks much worse on paper, but a broadly diversified portfolio did not do nearly as bad. A substantial allocation to treasury bonds and, even more so, to uncorrelated alternative strategies, most prominently trend-following managed futures, would have dampened the drawdown considerably.

Explicit bear market strategies had the opportunity to profit from extended downtrends – an opportunity that didn’t really exist in last year´s choppy sideways move in many assets. 

In 2018, in contrast, the only portfolio that merely lost 7% for the year (but with a drawdown of more than 20%) was concentrated US large cap exposure – pretty much every other asset has performed worse. Diversification actually brought drawdowns close to the worst level for a globally diversified portfolio reached in 2008 at -26% according to Meb Faber´s research.

Bad performance everywhere

Of course, the exact numbers depend on the asset and strategy mix you use, but 2018 was the year where most asset classes posted negative returns and most alternative strategies suffered.

Asset classes
We saw an all time record high percentage of assets posting a negative total return with data going back to 1900 according to Deutsche Bank:

Alternative Strategies of all kinds had a tough year as well:

Hedge Funds posted losses overall as indicated by the Barclay Hedge Fund Index´s negative performance of -4%.

Dividing the realm of alternatives into some of its major strategies doesn’t show a place to hide from those losses either:

Trend following CTA´s had an overall bad year. Luke Ellis, chief executive of Man Group, running the largest european trend-following fund, said momentum strategies had struggled with a lack of strong trends, or trends that abruptly reversed.

Equity markets behaved quite moderately in comparison to reversals of historic proportions as, for example, in the oil market.

A variety of indices following the industrie´s performance show losses between 5% and 8%. (e.g. BTOP50 Index -5%; Credit Suisse Managed Futures -7%; SG Trend Index -8%)

Alternative Long/Short Factor Strategies performed badly prompting AQR´s Cliff Asness, who runs one of the the largest of these strategies, to write a great piece on the vagaries of the markets and the pain it causes entitled “Liquid Alt Ragnarok“:

“Assuming you can create an investment process with a true 0.40 Sharpe ratio (0,43 for US stocks), and assuming a normal distribution (which is usually a better assumption the longer your horizon), your chance of positive returns (over cash) for any given day is 51%. For any month, it’s 55%. For any six-month period, 61%. For any year, 66%. For five years, 81%. For ten years, 90%. That sounds pretty great, no? It is. But there’s also a 10% chance that the investment strategy you created is as good as investing in the stock market and yet you fail to make a dime over cash for a decade. Still, the math would show, and basic common sense would agree, that finding an investment process you truly believe is as good as the stock market, yet not correlated to it, would be a pretty great thing.”

This is a great reminder, that we as individual investors definitely do not have control over what happens in the market, but rather have to accept what is given.

The Credit Suisse Liquid Alternative Beta Index is down -5% and its Long/Short Liquid Index -7% for 2018.

Short Volatility Strategies blew up in February and, after a period of recovery, suffered again at the end of 2018. The SG Volatility Trading Index was down -5%, but many over-leveraged traders are out of the game altogether. One prominent example is the blow up of funds run by due to extreme short option exposure to the volatile natural gas market. Margin calls cost investors more than the money they had actually invested in the fund.

Short Term Strategies as a whole went nowhere, which is actually the best result across alternative strategies: the SG Short Term Traders Index is flat at 0,26%. Unfortunately this seems to be just about the average result one can expect from short term strategies over the long term, if one looks at the historical data of the index.

In short, the probability to have been invested in a strategy that actually made money this year was very low and most likely would have been a choice influenced by luck more than skill. 

Cash was king in 2018

The best course of action would have been to take the regime change indications in February very seriously and go to cash. 

The big question, when taking such protective measures, is, not only which indications to follow to get out, but also: when to get in again?

My own indicators certainly pointed to the return to a normalized environment from April to October. A rational investor, that is in tune with the current market regime as indicated by his strategies, should have re-entered the market during April and then gone back to cash (or lower exposure) in October. He would have suffered two big drawdowns in 2018 as a consequence and would have likely posted an overall loss for the year, albeit with a much more moderate drawdown.

So, where does this leave us? 

2018 has clearly shown, that there is no holy grail in investing – every strategy has losing periods. Furthermore even uncorrelated strategies can post losses at the same time and sometimes we will witness bad periods virtually across the board. This tends to happen during severe bear markets, but can happen in other periods as well – this time it may have been part of late cycle behavior.

We will just have to take this in stride and move on.

Looking at equity markets now, specifically the S&P 500 as the most followed benchmark, I see an interesting divergence between the severely negative technical state of the market and the largely sound fundamental environment which only shows partial deterioration. Which side is likely to win the battle? Are technical indications a sign of something around the corner, that we just don’t know about yet, or is the market overreacting temporarily to slightly worse fundamental conditions?

I will look into these questions more closely in my next post.

To a successful 2019!

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