What Makes Trend Following Work?
John W. Henry & Company has one of the longest continuous trading records
among commodity trading advisors and hedge funds. That fact hardly needs to be
mentioned, as the firm is also one of the best known CTAs. This is due in part
to Mr. Henry's interest in baseball and his sports celebrity status as the
principal owner of the Boston Red Sox, but also to the firm's almost 30 years of
John W. Henry & Co. started to take clients in 1982. While the general strategy
is systematic trend following, there are eight programs with distinct
risk/return profiles. By the end of 2005, the firm managed several billion
dollars. But the following years were difficult and some of the programs went
through steep drawdowns. Current assets are less than $300 million.
Despite the volatility that drove away clients, the overall performance of
certain John W. Henry & Co. strategies is impressive. The longest running
program, the Financial and Metals Portfolio, has an annualized return of over
21% since inception. This program did very well this year, even as many trend
followers had negative or flat returns.
President and chief operating officer Ken Webster is in charge of daily
operations as well as product development. Mr. Webster has been with the company
for 16 years and its president since 2007. Here he explains the behavioral
underpinning long-term trend following and discusses its difficulties, strengths
JW Henry Co.'s Ken Webster
"We have made changes to our programs and models... but the underlying core
philosophy as to how investors view and analyze data has not changed."
Opalesque Futures Intelligence: Have markets changed since you got into
Ken Webster: Markets have changed and will continue to change as they have since
the inception of organized trading. That belief is at the core of trend
following and why an approach that utilizes market prices and not subjective
fundamentals continues to provide value to investors. The technology has changed
and there are now many more futures markets available, allowing us to expand the
diversification benefits to investors. We trade in over 80 global markets today
compared to 10 contracts - which were mostly in agriculture - when the firm
began almost 30 years ago. We trade only liquid markets, where we're convinced
there will be no problem getting in or out of positions. The number of liquid
contracts continues to grow, offering greater variety. Liquidity is not our only
criteria for trading a market and we do extensive research and testing on new
contracts before exposing clients. Any new markets under consideration are
traded in a proprietary account, to acquire the experience. Some markets do not
add value because they are highly correlated to our existing portfolio so they
are not traded. Some, like weather and carbon contracts, are in their early
stages and do not contain the liquidity required, but we continue to watch them.
OFI: What caused difficulties for trend followers over the past five
KW: 2005 and 2006 were difficult for most CTAs, depending on the specific
strategy. The whole world was in euphoria. There was no volatility and little
thought of the downside to skyrocketing investments that had little basis in
reality-like in real estate and stocks. When the environment becomes
disconnected like that, real movements in underlying markets become muted.
Markets are range-bound, stuck between a floor and a ceiling, with no long-term
price movements. It is a bad environment for CTAs with long-term trading
strategies. Those are periods to continue research to see if any modifications
to the approach would yield benefit but not a time to abandon your long-term
beliefs and investment experience. Eventually reality catches up to every bubble
and presents opportunities for long-term investors. 2008 was a reality check for
the globe and presented many opportunities for CTAs and their clients.
OFI: Why was last year difficult for many CTAs?
KW: In the past 18 months there was a reversion to range-bound activity. Markets
are now led by whatever information comes out about government support for
recovery. There isn't a clear signal to investors that the danger of another
"2008 style" meltdown has been averted. If you look at the S&P 500, in the past
three months half of the trading days resulted in a move in excess of 1% from
the prior day's close, with over half of those days moving to the downside. This
is a clear sign that there is no real investor conviction. While the past five
years contained difficult market periods for trend followers, our performance
results for this period are double-digit positive while equity markets are
negative for both the five- and ten-year periods.
OFI: What makes money in the current environment?
KW: Looking at 2010 performance, we made money in certain market sectors
including interest rates and currencies, resulting in positive year-to-date
performance in many of our programs. Other sectors have been mixed, not
providing clear trends. This is why we trade a diverse portfolio of sectors and
markets to cast a wide net of opportunities, not knowing where the next trend
will emerge. An example of one market that has been in focus recently is wheat.
In the first half of the year wheat was in a clear down trend, dropping over 20%
from last year's close, only to reverse midyear after reports of a heat wave in
Russia affecting supply. There was a rally of over 80% from the June low to a
new high in early August. We were well positioned for these movements in our
programs that trade wheat.
OFI: How is the John W. Henry Financial & Metals program doing?
KW: The Financial and Metals Portfolio is doing well this year, up
approximately 15% through August. It has outperformed its peer group and other
more diversified offerings by sidestepping some of the difficulties experienced
this year in the energy and agricultural markets. It is our oldest program but
not the biggest in terms of assets. This program has excellent long-term returns
but historically has shown higher volatility to achieve those returns over time.
We have other programs, developed in our ongoing research efforts to provide
complements to the Financial & Metals program. JWH Global Analytics program is
our largest program, having launched in 1997, and the Diversified Plus program
was launched with client assets in 2007. All are doing well relative to our
peers in a difficult market environment.
OFI: Why does trend following continue to work?
KW: Trend following maintains that market prices rather than market
fundamentals are the key aggregators of relevant investment data. Trend
following is an analysis of how people analyze and then react to all investment
information at their disposal. Many things have changed in the investment
industry over the years, including trading technology and the speed and
availability of market data, but what has not changed is the fact that humans
analyze, interpret and react to market information differently and at different
rates. That innate difference is at the core of what creates market price trends
and the reason trend following continues to work. If you were to ask 10
investors with access to the same market data what impact that data will have on
market price, you will get 10 different answers or predictions.
OFI: What would you do differently in view of recent years' experience?
KW: We have made changes to our programs and models since our inception,
but the underlying core philosophy as to how investors view and analyze data has
not changed. We believe that people can't consistently predict the future. I've
been through many different market cycles over the past 25 years. You learn that
as investors we are our own worst enemies. People are emotionally attached to
their market predictions and so often make very bad decisions, especially during
times of crisis. One of the advantages of a systematic and disciplined approach
to investing is that it takes away the emotional bias that often leads to poor
OFI: Are people more receptive to investing in managed futures?
KW: Investors of all size and sophistication have suffered through the
economic collapse in the past three years and are certainly rethinking their
long-term strategies. They thought they were broadly diversified by holding
domestic and international stocks, but those supposedly diversified investments
all correlated in 2008 and went down together. Investors have greater
understanding of correlation and non-correlation now than ever before. There are
not many asset classes that have the ability managed futures does to add
diversity to a traditional portfolio at times of stress but also provide
excellent long-term absolute returns in times of economic prosperity. These
investors are exploring the potential benefits of CTAs and as they regain
confidence in the overall economy and bring assets back into the market, managed
futures are being considered as a component of their overall asset allocation.