The Hedge Fund Strategy That’s Winning This Year

The Hedge Fund Strategy That’s Winning This Year
Russell Burns

over 1 year ago5 mins

  • Trend-following strategies have worked well in 2022 and could be a good addition to your portfolio.

  • The old “don’t fight the Fed” mantra now suggests steering clear of equities and bonds.

  • Buying inverse bonds and equity ETFs and going long the USD are ways to hedge or speculate if the current trends continue.

Trend-following strategies have worked well in 2022 and could be a good addition to your portfolio.

The old “don’t fight the Fed” mantra now suggests steering clear of equities and bonds.

Buying inverse bonds and equity ETFs and going long the USD are ways to hedge or speculate if the current trends continue.

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Trend following has been one of the best-performing hedge fund strategies this year – the SG Trend Index has climbed 29.6%, while the S&P 500 has fallen 19%. Those trend-following investors have managed such eye-watering returns by focusing on the price signals, seeking out momentum plays, and keeping in mind that old mantra: don’t fight the Fed. Let’s take a look at what they’re doing right…

What is the trend-following strategy?

Trend following aims to take advantage of the long, medium, or short-term trends in financial markets. They don’t aim to predict those trends, but rather to jump on them as they’re occurring. That means identifying major trades and shifts that have momentum – and capitalizing on them.

The trend-following strategy works by either buying high and selling higher, or by short-selling low and exiting your short at an even lower level. You can implement a trend-following strategy using the 100- and 200-day moving averages on the markets you follow – essentially, leveraging them to guide your entry points and exit points. The key is to follow the price of the asset and let the profits run.

Take a look at how this would have played out in recent years if you were investing in the Nasdaq 100. When the 100-day moving average (green line) and 200-day (yellow line) crossed over in May of 2019, your trend-following strategy would have had you “going long”, or investing in the index’s tech stocks. And it would have had you holding on until April 6th of this year, when the 100-day moving average line crossed over the 200-day moving average. At that point, your strategy would have had you switch your long position for a short one, and would still have you in that short today.

Nasdaq 100-day moving averages. Source: Bloomberg
Nasdaq 100-day moving averages. Source: Bloomberg

If you have more time and prefer to take a more active role in adjusting positions, you can use shorter moving average periods, trend lines, or maybe a combination of all three. But for a simple, less time-consuming approach, the 100-day and 200-day moving average crossover gets the job done.

How has the Fed played into all this?

This year, the Fed has been driving trends in just about every market. That includes weakening stocks, rising bond yields, and the strengthening US dollar.

Since the global financial crisis in 2008-09, the popular mantra in the markets was “don’t fight the Fed”. Central banks, including the Fed, had lowered interest rates to near zero and authorized massive bond-buying programs, overall offering an “accommodative” stance that encouraged investment and ultimately got the economy humming again.

But lately, inflation’s hit levels not seen in 40-plus years, and the Fed’s been forced to change its narrative – dropping its previous accommodative stance like it was hot. Its aim is to now bring inflation, which hit a peak of 9.1% in June, back down toward the central bank’s 2% target, even if it results in pain for the economy. This week, investors are expecting a 0.75 percentage point rate increase from the Fed, with more to follow.

But there is now a strong alternative to stocks, six-month T-bills are returning nearly 4% as rates paid on cash deposits rise in line with expected Fed rate hikes. Last week, hedge fund billionaire Ray Dalio said that at 4.5% interest rates, equity markets could fall 20%. And Goldman Sachs published a report estimating that if Fed tightening leads to a US recession, the S&P could fall 27%. While inflation is the Fed’s primary concern and it is running high, the “don’t fight the Fed” mantra now suggests a very different tactic: steering clear of both stock and bond markets.

What’s the opportunity?

As interest rates and recession fears rise, you’ve likely already considered increasing your allocations to the market’s more defensive sectors, like healthcare, utilities, and others – they’re likely to be more insulated from an economic downturn, after all. But you might not want to go all-in on any one of these: a US recession could send most stocks lower, leaving nowhere in the market to hide.

Instead, consider allocating part of your portfolio, either as a speculative move or a hedge, to trend-following type strategies. These should allow you to invest in the current direction of the market and “enjoy the ride”. But rather than trying to predict what the Fed will do next, you’re probably a lot better off using simple moving average trend following strategies. Right now, these are some of the ETFs which are trending:

Performance year-to-date of ETFs. Source: Bloomberg
Performance year-to-date of ETFs. Source: Bloomberg

ProShares Short 20+ Year Treasury (ticker: TBF US; expense ratio: 0.91%) delivers returns of the inverse (opposite) of the daily performance of the ICE US Treasury 20+ Year Bonds Index. Higher interest rate expectations would be expected to lead to this ETF rallying further. Simply Interest Rate Hedge ETF (PFIX US, expense 0.5%) is more volatile and risky, meanwhile, and provides a hedge against a sharp increase in long-term interest rates.

ProShares Short S&P 500 ETF (SH US; 0.89%) delivers returns that correspond to the inverse of the S&P 500. (So when the S&P 500 performs poorly, it does well). ProShares Short QQQ (PSQ US, 0.95%) delivers returns that correspond to the inverse of the Nasdaq-100. Both of these ETFs could be expected to perform well if US recession fears heighten.

WisdomTree Long USD Short GBP (GBUS; 0.39%) is an ETC (Exchange Traded Certificate) that tracks movements equivalent to a long position in the US dollar vs the British pound. The UK economic outlook remains bleak, suggesting the safe-haven US dollar will continue to gain against the pound, even if expectations dwindle for further US interest rate hikes.

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Disclaimer: These articles are provided for information purposes only. Occasionally, an opinion about whether to buy or sell a specific investment may be provided. The content is not intended to be a personal recommendation to buy or sell any financial instrument or product, or to adopt any investment strategy as it is not provided based on an assessment of your investing knowledge and experience, your financial situation or your investment objectives. The value of your investments, and the income derived from them, may go down as well as up. You may not get back all the money that you invest. The investments referred to in this article may not be suitable for all investors, and if in doubt, an investor should seek advice from a qualified investment advisor.

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