Taking human judgement out of equity portfolios can help investors stay ahead of market reversals

KEY TAKEAWAYS:

  • A systematic strategy with a contrarian biased is well suited to benefiting from markets volatility. A systematic approach based on market signals removes human emotion and error. Contrarian trading establishes when momentum is starting to weaken and the market is changing direction.
  • The strategy outperformed during one of the worst market downturns. In 2008, it returned 13%, compared with a 44.4% loss for Euro Stoxx 50 investors and a 37% fall in the S&P 500.
  • The contrarian strategy is reactive to major turning points in equity markets and so is complementary to long-only portfolios. It can also act as a diversifier for fixed income portfolios given its aim to provide consistent and stable long-term returns.
It is natural for investors to seek to protect their portfolios against volatility. There always seems to be something around the corner to worry about: the US-China trade war, the fear of recession, Brexit and the instability of the world order are currently keeping investors wake at night. The crystallisation of any of these could lead to a sudden and damaging drop in the value of assets. So strategies to protect against falling markets are constantly sought and evaluated. But what if markets surprise on the upside? This is another fear of institutional investors – that in protecting the portfolio against a potential fall in asset prices they miss out on a strong market rally.

Both types of fear are rational. And both can be addressed by a systematic contrarian strategy – that is, an investment strategy which generates returns by betting against market trend and harvests alpha every time markets make significant detours, whether those detours are up or down.

The fallibility of the human psyche

So why is a systematic strategy suited to managing volatility? And why a contrarian approach?

The answer to the first question lies in the fallibility of the human psyche. A systematic approach based solely on market signals removes human emotion and error. Even the most experienced and skilled analysts are prone to excitement or fear, and can misread market signals. “This is most likely to happen when there is considerable market “noise” such as Twitter activity from well-followed accounts, or other noise that leads to short-term price action,” says Jean-Jacques Duhot, chief investment officer at Arctic Blue Capital, an affiliate of H2O Asset Management.

To answer the second question, an embedded contrarian bias can detect sustainable changes in market direction. This distinguishes the strategy from others that follow short-term switches in market direction which rapidly reverse, potentially creating losses. It also differentiates the strategy from pure long-term trend following, which reverses tack only when trends are well established. The purpose of a contrarian systematic strategy is to see through the noise and anticipate durable changes in the market. The strategy aims to stay ahead of mainstream investors and shift the portfolio to a contrarian position before a trend is fully established.

How to spot trend reversals

So how does the strategy anticipate market surprises?

“The first thing to say is we are not predictive, we do not look at the macro picture,” says Duhot. “We are reactive, aiming to react before others can.” That is, Arctic Blue spots trends and jumps on them before other investors, rather than trying to outright forecast coming market trends. To do this, it employs two models: trend and reversal. The trend model, to which only a minority (20%-40%) of the strategy’s assets are allocated, follows momentum over both the medium and long-term. The bulk (60%-80%) of the assets, however, are allocated to the reversal (or contrarian) model, which generates the larger share of returns. The contrarian model looks for when momentum is starting to weaken and there is consequently a higher probability that the market could change direction.

Some of the reversal models focus on the midterm, anticipating sharp V-shape reversals that take place as a result of excess investor positioning or exogenous events, such as political upheaval, a pandemic or a terrorist incident. Other reversal models are longer term, tracking fundamental shifts that play out over long periods. Each model can trade a wide array of geographical markets – Asia, US, Germany, UK etc – and also sectoral markets such as biotech, financials, energy and so on. They can also take positions based on idiosyncratic events such as Brexit, national elections and central bank decisions.

These two opposing groups – trend and reversal – of virtual traders operate independently and without reference to each other, so the combined information identifies potential inflection points in the cycle. The combination of trend and reversal models indicate increasing probability that a market is reversing and Arctic Blue adjusts its weights in each of the models as the probability grows. When market signals indicate a coming downturn, the trend model typically cuts its long position, while the reversal model builds a short position. This process continues until market signals indicate that the trend is slowing, or reversing.

Reacting to the real world

The systematic contrarian strategy was created by Arctic Blue in 2007 in response to concerns of a large institutional client about the health of the world economy at that time. The strategy did its job amid the worst market downturn in living memory. In 2008, as the credit crisis unfolded, the strategy returned 13%.

Arctic Blue   VolatilityAtlanterra strategy
But just as striking is the strategy’s performance in 2009, when central banks rode to the rescue of the global economy and markets staged a remarkable and largely unanticipated V-shaped recovery. The strategy returned some 24%, with the reversal model generating a substantial 28% return (and the trend model losing 4%).

“At the start of 2009, the entire world was bearish and underinvested,” says Duhot. “The trauma of Lehman Brothers caused investors everywhere to seek protection. Protection became hugely overpriced.” Arctic Blue’s models detected this and observed the shifts in momentum before they became evident to the broad market. The strategy shifted to a 150% net long exposure in 2009, aggressively positioning the portfolio to capture a big chunk of the V-shaped recovery.

How does a contrarian strategy fit with the wider portfolio?

The strategy provides investors with an equity allocation which is reactive to major turning points in the equity markets and is therefore complementary to long-only portfolios. Since it has low correlation with major stock indices, it is a natural diversifier for equity portfolios, particularly at times when long-only strategies are performing poorly.

Atlanterra Correlation EN
It can also act as a diversifier for fixed income portfolios in that it is designed to provide consistent and stable long-term returns. It targets a 5% annual return with target volatility of just 5%-7%. It is therefore a viable alternative to the increasingly common practice of adding potentially risky high dividend-yielding stocks to the portfolio.

Additionally, the strategy is complementary to CTA funds, which are typically consensus trend followers, whereas Arctic Blue’s strategy is a contrarian trend spotter.  The flexible weightings within the strategy mean that investors benefit from incremental positioning. In other words, as volatility rises, the strategy adjusts its allocations to provide increasing protection from sudden changes in value without the investor having to allocate more funds to the strategy. One way of looking at the strategy is it outsources investors’ need to position their portfolios for medium- and long-term changes in market direction.

Finally, because it generates alpha on both the up and down sides of markets, it can be seen as an absolute return generator.

Conclusion – the advantage of being agnostic

Investing in markets is psychologically demanding. A constant stream of apparently bad news does not always seem to feed into asset prices. In fact, bad news can often equal good news, given that policymakers are likely to ease monetary and fiscal conditions on bad news. At the same time, fears remain that central banks and governments cannot support markets forever.

Few investors are equipped to pick their way through these contradictory arguments and position their portfolios accordingly. “A strategy which is agnostic about the causes of market trends, but reactive to the trends as they emerge, can help square the circle,” says Duhot. In a market that defies rational comprehension, a systematic approach, which takes human fears and hopes out of the equation, can anchor and add alpha to most institutional portfolios.
Published in December 2019

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This communication is for information only and is intended for investment service providers or other Professional Clients. The analyses and opinions referenced herein represent the subjective views of the author as referenced unless stated otherwise and are subject to change. There can be no assurance that developments will transpire as may be forecasted in this material.

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