(Extract from paper by Marko Kolanovic, Global Head of Derivative and Quantitative Strategies, J.P. Morgan Securities)
Assets in trend-following strategies (CTAs) are currently over $330bn. The impact of CTAs on asset prices is to extend existing price trends and to increase the convexity of asset returns. For instance, a fundamentally triggered selloff in oil or government bonds may be prolonged and accelerated by the compounding effect of CTAs increasing short positions.
The table above summarizes estimated CTA flows (in $Bn) for US, Europe and Japan equities, bonds, USD, oil and gold. We have assumed CTAs follow 1-12M trend signals and monthly rebalance based on an equal risk contribution. First we can examine flows over the next 30 days assuming asset prices don’t change (in this case CTA flows occur due to roll-off of momentum signals and recent shifts in asset volatility). Assuming no asset moves (0% returns), CTAs would need to decrease their allocation to US equities and Japanese bonds ($15 and $63 Bn, respectively), and increase their allocation to commodities (e.g. $6bn into Oil).
Moves in asset prices could trigger significant changes in CTA allocations. These changes can be quite convex (e.g. CTAs may need to buy a different amount in an upside move, than sell in a downside move scenario). Looking at larger moves (e.g. 5% or 10% moves), there is significant negative convexity for equities (i.e. if US equities drop 10%, CTAs would need to sell $77bn, and if equities rally 10% CTAs would need to buy only $21bn, i.e. $56bn negative convexity), and significant positive convexity for gold and bonds. For instance, if gold were to rally 15%, CTAs would need to increase their allocation by $39bn and if it drops by 15%, they would need to decrease by only $3bn ($37bn positive convexity). Investors can use these estimates to gauge upside/downside risk in various assets that could be amplified by changes in CTA allocations.