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Trend-Following Strategies for Tail-Risk Hedging and Alpha Generation

Last Updated on 10 February, 2024 by Rejaul Karim

Delving into the realm of trend-following strategies, “Trend-Following Strategies for Tail-Risk Hedging and Alpha Generation” by Artur Sepp, from Clearstar AG, dissects the adaptive nature of these strategies in generating positive skewness and convexity. Published on May 9, 2018, this paper unveils the unique capacity of trend-followers to offset frequent small losses with infrequent large gains, resulting in a positively skewed return profile.

Moreover, these strategies demonstrate positive convexity concerning stock market indices, particularly during extreme market conditions. The study navigates through the practical intricacies, analyzing how trend smoothing parameters and return measurement frequencies influence skewness and convexity profiles.

As the narrative unfolds, the paper emphasizes the strategic role of trend-followers as potent diversifiers and alpha generators in both long-only portfolios and alternative investments, offering valuable insights into the synergy between trend-following and stock momentum strategies.

Abstract Of Paper

Because of the adaptive nature of position sizing, trend-following strategies can generate the positive skewness of their returns, when infrequent large gains compensate overall for frequent small losses. Further, trend-followers can produce the positive convexity of their returns with respect to stock market indices, when large gains are realized during either very bearish or very bullish markets. The positive convexity along with the overall positive performance make trend-following strategies viable diversifiers and alpha generators for both long-only portfolios and alternatives investments.

I provide a practical analysis of how the skewness and convexity profiles of trend-followers depend on the trend smoothing parameter differentiating between slow-paced and fast-paced trend-followers. I show how the returns measurement frequency affects the realized convexity of the trend-followers. Finally, I discuss an interesting connection between trend-following and stock momentum strategies and illustrate the benefits of allocation to trend-followers within alternatives portfolio.

Original paper – Download PDF

Here you can download the PDF and original paper of Trend-Following Strategies for Tail-Risk Hedging and Alpha Generation.

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Author

Artur Sepp
Clearstar AG

Conclusion

In conclusion, the adaptive nature of position sizing in trend-following strategies unveils a distinct advantage in generating positive skewness, where infrequent but substantial gains offset frequent small losses. Moreover, these strategies exhibit positive convexity concerning stock market indices, particularly thriving in either highly bearish or bullish market conditions.

This unique combination of positive skewness and convexity positions trend-following strategies as valuable tools for diversification and alpha generation, catering to both long-only portfolios and alternative investments.

The analysis of the skewness and convexity profiles, influenced by the trend smoothing parameter and returns measurement frequency, adds a practical dimension to understanding the dynamics of trend-followers. The evident connection between trend-following and stock momentum strategies underscores the strategic benefits of allocating to trend-followers within alternative portfolios.

Related Reading:

Betting Against Correlation: Testing Theories of the Low-Risk Effect

Strategies Can Be Expensive Too! The Value Spread and Asset Allocation in Global Equity Markets

FAQ

Q1: How do trend-following strategies generate positive skewness, and what is the significance of this in terms of return profiles?

Trend-following strategies generate positive skewness by adapting position sizes, allowing infrequent but substantial gains to compensate for frequent small losses. This results in a positively skewed return profile, where the strategy offsets common losses with occasional significant gains, enhancing the overall performance.

Q2: What is the positive convexity exhibited by trend-following strategies, and how does it relate to stock market indices, especially during extreme market conditions?

Trend-following strategies demonstrate positive convexity concerning stock market indices, particularly during extreme market conditions—either very bearish or very bullish. This positive convexity indicates that the strategies realize large gains during these exceptional circumstances, contributing to an overall positive performance.

Q3: How do the practical aspects, such as trend smoothing parameters and returns measurement frequencies, influence the skewness and convexity profiles of trend-following strategies?

The paper highlights that the skewness and convexity profiles of trend-following strategies depend on practical factors like trend smoothing parameters and returns measurement frequencies. The analysis provides insights into how these parameters influence the realized skewness and convexity of the strategies, adding a practical dimension to understanding their dynamics.

You can find many more Research Papers here

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