The strategy designed to perform when asset prices trend

When I first started in markets, I was taught a rules-based, equities momentum strategy. “The trend is your friend” and “be right and sit tight” were the maxims I lived by.

The “rules-based” part meant that I only engaged with the market under certain, favourable conditions, and the “momentum” part meant that I only bought stocks that were going up, and only sold stocks that were going down.

One of my early mentors who taught me the strategy also taught me that the key benefit of employing it was that I didn’t have to be fully invested all the time. Rather, I only had to take on risk when the conditions for the strategy were optimal.

Unlike most investors (and funds for that matter) who need to be fully invested or invested up to a certain amount no matter the market conditions, such a strategy provides much more flexibility - both directionally (long and short) and with respect to the amount of risk taken on at any point in time.

Not having to be invested all the time means that such a strategy offer tremendous diversification benefits within a portfolio. This view is shared by PIMCO Executive Vice President, Chris Santore, who heads product strategy for PIMCO's quantitative strategies business. 

When speaking about the PIMCO Trends Managed Futures Strategy he says: 

We think [diversification] is the key driving force for why investors have embraced managed futures allocations.

Its ability to consistently deliver returns that are both different to the rest of the portfolio and that have been consistently strong in environments that are really challenging for allocating portfolios, crises like the first quarter of 2020, and years like 2022 when both stocks and bonds experienced large selloffs

In this wire, Santore and I explore the strategy the PIMCO Quant team employs, the benefits that it can provide within a portfolio, and how the strategy operates in the real world.

What are managed futures strategies?

Managed futures strategies are portfolios that look to follow trends in the prices of a wide variety of global assets, including but not limited to bonds, currencies, commodities, and equities.

If something has been going up in price, or down in price with some persistence, then a managed futures strategy might invest in the direction of that trend, seeking to capitalise on the persistence of these trends over time.

Santore points out that often the opportunity in these markets shows up at precisely the time investors seeking diversification would want:

“Namely periods of time that are characterised by high market volatility and often drawdowns in asset classes like equities that investors have large allocations to. So, it's a strategy that uses a relatively unique approach to investing, executed with a lot of discipline, but its role in a portfolio is to provide diversification without sacrificing return”.

And this is what a managed futures strategy is supposed to do. It is supposed to be different. “That’s the whole point," notes Santore.

Rather than traditional investment strategies, which often require taking a view of what’s happening in the world, a managed futures strategy “uses computer models seeking to detect the presence of momentum in prices and recognises the fact that a strategy doing that can deliver negative correlations to most asset classes while making money over time, delivering a really valuable return stream to investors”.

Ultimately, “it’s a disciplined way of systematically thinking differently,” says Santore.

Discipline is the key

Ask any rules-based investor and they will tell you that discipline is one of the keys to success. There is no point in having rules if you are not going to adhere to them when markets go sideways.

The rules also ensure that you don’t revert back to your own biases when the system gets tested, which invariably it will. For PIMCO, adherence to the rules is paramount.

“It's hardcoded into how the strategy works, so we want to seek to maximise the diversification within the portfolio”.

"We want to trade a wide variety of underlying markets with position sizes carefully calibrated to maintain, on average over the long term, about equal risk contribution from all of the underlying markets that we trade”, he adds.

What that means in practice is that PIMCO doesn’t take a particular view and doesn’t seek to implement particular views that any market or market sector is better or worse for trend following.

“Over the long run, we want to have position sizes that are adaptive to where the models find opportunities in any given market environment that over the long run are calibrated to the risk parameters that we seek to achieve for the strategy overall”.

Does what it says on the tin

For the PIMCO team, the Trends Managed Futures strategy means one thing – “it’s a pure trend following strategy”.

“All of the underlying models are seeking to follow trends in the prices of the assets that we trade. We have a few different ways to do that, but they all have the same general characteristics in that they're seeking positive returns, low correlation to underlying asset classes with the potential to deliver excess alpha via strong performance in high-risk market environments”.

“We don't want to incorporate strategies that are likely to violate those objectives, and we've been very careful about what goes into this portfolio."

For the hardcore strategy nerds out there (myself included), Santore explains that the primary models used are time series momentum strategies, and the portfolio is biased towards a relatively fast set of time series momentum models.

“That's designed to give the portfolio a bit more of a defensive orientation versus other managed future strategies that might be more balanced across different timeframes and oftentimes, in fact, skew to a bit of a slower timeframe”.

Santore goes on to explain that the PIMCO view “is not that a faster signal generates necessarily better risk-adjusted returns over the long run”, rather, “we are convinced that it gives the portfolio more reliable defensive properties and that's one of our priorities - and one of the ways that we differentiate ourselves versus others”.

The strategy trades in approximately 150 markets and Santore notes that “we'll often have positions open in many of them, but positioning is dynamic and entirely dependent on the market environment”.

And finally, as one would expect with a strategy like this, the turnover in the portfolio is quite high. “It's a relatively high turnover portfolio where you have to change positions relatively quickly to capture this sort of a return profile, so that's something we embrace and we partner closely with PIMCO's global execution teams to manage the trading in this portfolio on our behalf,” says Santore.

Real-life examples

When asked for a real-life example of the types of opportunity that the strategy pursues, Santore talks about March 2020 and the onset of the pandemic.

“This was an interesting environment for a lot of reasons, but one where trend following strategies had detected trouble in the markets ahead of the event that we all remember in March 2020.”

“The news related to the developing pandemic situation was making its way into the prices of other asset classes prior to the real crisis environment in March, so interest rates were rallying, commodities were selling off, the US dollar was rallying," notes Santore.

He says there was effectively a slower-moving flight to safety underway in asset classes other than equities going into March, “but equity markets continued rallying through much of February until things changed and it became clear that an economic shutdown was coming”

Santore goes on to recall that the market reaction was then uniform and swift to the developing pandemic, and the portfolio adapted quickly to the risk-off environment that emerged across all asset classes, including equity markets in March.

“We were able to capitalise on positive returns from across the portfolio through that event by both taking directional positions that were responding to the information that was present in the market going into the event, and then reacting quickly to the event as it unfolded in the early part of March”.

Santore also talks about the value of trading a wide range of markets that can capitalise on idiosyncratic trends in addition to the major macro events. PIMCO’s ability to stretch beyond just the typical trend-following markets into areas like European commodities and interest rate swaps have uncovered valuable opportunities in recent years.

“We see a lot of opportunity in markets that are not accessible through the more typical futures and forwards contracts. For example, by incorporating interest rate swaps, we’ve been able to gain access to a much wider universe of instruments, including regions such as Eastern Europe and Latin America that have seen much larger interest rate increases over longer periods of time than we’ve seen in the traditional developed market economies, all while leveraging PIMCO’s existing infrastructure and expertise.”

“Those markets gave us broader exposure to the event that was playing out in that period of time and that's really valuable in a portfolio”.