Choose Your Friends Wisely February 2013 Success in a trend-following strategy depends on selecting the right asset classes, instruments and trend durations, says Steve Jeneste of Goldman Sachs Management The trend may be your friend, as the old investing adage has it. But as is the case with friends of the human variety, it can be more enriching to pursue relationships with certain assets. Managed-futures vehicles that employ trend-following strategies potentially can be profitable if there is sufficient diversification among the trends the managers are trying to capture, says Steve Jeneste, senior portfolio manager on the Quantitative Investment Strategies team at Goldman Sachs Asset Management. In his view, managed futures can also help suitable investors achieve broader portfolio diversification, given the low correlations such funds typically have with conventional types of investments. Jeneste discussed his approach and market outlook in an exclusive interview with Morgan Stanley Wealth Management. The following is an edited version of his comments. Question:What is your background? Steve Jeneste: I ve been at Goldman Sachs on the same team for 14 years doing portfolio management and research. The team itself is one of the largest, if not the largest, quant team in the world. We have 140 professionals--including about 50 portfolio managers and researchers supported by 25 traders and almost 50 professionals in IT, among others. It s a large team supporting all of our activities, in particular managed futures. Question: Can you talk about your process and your systematic approach? Jeneste: We are looking at trends in about 70 instruments across the globe in seven asset classes. It s purely systematic. As we sense an upward trend developing, say in the S&P 500, we will add to positions. When the trend starts to go down, we will reduce positions. And when the trend turns negative, we cross the zero line and go short. It s important to realize that this strategy does not have a long or short bias. We are pretty much agnostic in our approach [within the Goldman Sachs Managed Futures Strategy Fund]. Question: What asset classes do you trade in? Jeneste: We trade equity country indexes and currencies in the G10 and emerging markets. We trade [interest] rates, so fixed income is really in the sovereign space in the G10. And we are looking at different maturity buckets of the yield curve, so short term and medium term [durations, as well]. Because of ongoing hearings in Washington regarding the use of commodities for mutual funds, we decided not to trade commodities. Fortunately, it doesn t have an impact on our process, so the inclusion or exclusion of commodities doesn t alter our ability to [potentially] add value. That is because of the breadth of our investment. [Since we] trade 70 instruments already, adding commodities wouldn t make much of a difference. Question: When you re trading these instruments, are you focusing on the most liquid contracts? Jeneste: Yes, that has been our approach. We have very long experience in trading [within] these strategies--[going]
back to 1989--in all asset classes (although the inception date for the Goldman Sachs Managed Futures Strategy Fund is 2/29/12). Drawing on that experience, we have selected for inclusion all the assets or instruments that are the most liquid and that trend the most. You can call it a bit of a specialist approach, trading the most liquid instruments. [We believe] that will add value, as opposed to [what happens with] a more generalist approach, which is to take all the assets one can possibly trade, put them in the machine and see what happens next. Question: When it comes to measuring a trend, obviously different people go about it differently. How do you tackle it? For example, do you look just at short-term trends, or long-term trends or something in between? Jeneste: Diversification is very important for investors, and it s a very important part of the process in [the Goldman Sachs Managed Futures Strategy] Fund. We try to maximize the benefits of diversification, not only by trading many instruments (70) or many asset classes (seven so far). We also diversify in our investment horizon, so we are looking at short-, medium- and long-term trends--all of them. We tend to prefer to put more emphasis on shorter-term signals than longer-term signals at the margin. That allows us not to be, so to speak, stuck in a particular trend, [a rut that can occur] if one looks at a very long trend. Question: What do you think would enable a systematic approach like trend following to work in the future? Jeneste: Trend following has been a strategy managed for many, many years--maybe one of the first quantitative ones-- and it has proven itself. Historically it has added value, and we believe the reason is that a trend-following strategy is taking advantage of what we call behavioral biases in the market. Two prominent ones are the disposition effect and conservatism. The disposition effect is very simple: It is the idea that investors tend to sell winners too early while holding on to losers too long. As a result, new information travels slowly into the market price. The second phenomenon, what we call conservatism, stems from the tendency of individuals to be too slow at changing their beliefs in the face of new information. It was, in fact, documented in the 60s that people tend to under-react, by a factor of two to five, to new information. [This means that] it doesn t take them one new observation to make a change; it takes them two--if they are faster, up to five. In financial markets this leads to an under-reaction to economic developments and other public news. Investors are people, and people have not changed since these observations were made, so the same behavioral biases will prevail. Question: What role do managed futures play in a portfolio? How do you think of managed futures in conjunction with a portfolio made up of other asset classes? Jeneste: We have done a lot of analysis on that. It s interesting to see that managed-futures strategies tend to do well as standalone investments--[not only] when you have market crashes but also when you have big, big rallies. You can go back in history and see, for instance, that after the tech bubble managed futures added value. We all know about that, and we know about 2008. It s important to note also that after the tech bubble in 2002, 2003 and 2004 managed futures added about 10% to 20%, depending on the indexes we are looking at. We re not talking about back tests here; we re talking about live managers, net of fees, and how they performed historically.there is no cherry-picking. Managed futures can do well in both kinds of big moves, positive or negative. The interesting thing is that adding managed futures to a portfolio [creates] this very different pattern of returns, and it s expressed in the correlations. The correlation is zero over the long run. Better than that, a managed-futures strategy that follows the trend will have a positive correlation with equities in an up market [and] a negative correlation with equities in a down market. That s a very interesting proposition for [suitable] investors [who] want a negative correlation in a down market. That s when they want diversification the most, and that s what managed futures will provide. You can contrast that to other standard strategies or hedge-fund strategies that have a long equity bias or some correlation. [These] will [potentially] add value in an up market and detract in a down market. [So] managed futures [can] be a good complement to a portfolio, although by definition we probably tend to do less well in the absence of a trend. Question: How is the portfolio currently positioned? Jeneste: The best [way to explain this] is to put it in the context of the trends and different investment horizons. What we ve seen in the markets in the last year is that the long trend has been in fixed income. With rates going down almost in a straight line, fixed income is an asset class that 2
has been doing very well for itself. Our program [sought to] capture that by having a maximum long position in fixedincome instruments, and we remain bullish in fixed income. Equity has been a [slightly] more challenging asset class for investors. The trend has definitely been up, but with some wide variations around that up trend. We were long in equities in the first quarter of 2012 and then in the second quarter we were actually net short in equities, [in both] developed and emerging [markets]. We moved to a more aggressive position first in emerging markets, where we saw some pickup, then finally in developed markets. Right now we are also long in most of the equity markets, including emerging markets. Finally, currencies have been the most challenging asset class, I think, for investors. We haven t really seen much of a trend there. The best example of that is the euro, which has been going up and down depending on market action, regulators and central bank intervention. All of this activism in the markets has made the currency fluctuate just in a range, and nothing much has happened. [So] we are relatively neutral. We recently increased our long positions in the Australian and New Zealand dollars, and we are net short in the yen. Currencies illustrate that even if an asset class hasn t had a real trend, we can be neutral overall [while] still having longs and shorts within the asset class. Question: How do you determine weightings? Jeneste: By design we didn t want a process that would be driven by one particular asset class and exposed significantly to a specific type of risk. So we have a very diversified approach. At the margin we have roughly equal long-term risk across all asset classes. Recognizing that, we can have trends in some asset classes over a quarter and then the trend goes to other asset classes. That s the first thing. As we look within an asset class and at the instrument level, the way that we build our portfolio is to recognize that not all trends are born equal. I like a short up trend, but what I like better--and what is more convincing--is a medium-term trend that has recently done well so that you also have this short-term trend [within it]. What we like even better than that is a trend that is confirmed in multiple horizons: long term, medium term and short term. We have much more conviction in that trend, and we ll have more weight there. 3
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