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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 history.

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 and prospects.

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 this business?
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 years?
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 investment decisions.

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.