Hedge fund techniques seemingly retain efficacy, albeit with a selective approach being adopted.
In an era where market momentum, fuelled by government cash influx, long-term views, and disregard for traditional analysis models, appears to be ruling the financial landscape, the challenge for hedge funds has become increasingly evident [1][2][3]. In response, a sub-set of hedge fund strategies that are less reliant on detailed corporate fundamental analysis are being considered as a means to mine alpha.
Jim Neumann, Partner and Chief Investment Officer at Sussex Partners, discusses this challenge in today's environment. He suggests that momentum-based hedge fund strategies, particularly momentum trading and trend following, are the most effective in such a market [1][2][3].
These strategies capitalise on the continuation of price movements driven by market psychology and sentiment rather than underlying value. They provide offense while offering protection, allowing portfolios to take advantage of escalating asset prices while having the ability to protect in a dislocation [1][2].
Momentum trading involves identifying assets showing strong directional movement (up or down) and riding the trend as long as it persists. Momentum traders use indicators such as Rate of Change (ROC), Moving Average Convergence Divergence (MACD), volume spikes, and breakouts to confirm trend strength and continuation [1][2].
Trend following, a subset of momentum strategies often linked with time-series momentum, expects that assets’ future price returns will follow their historical return direction. It includes entering long positions in securities in confirmed uptrends and short positions in downtrends, usually holding positions for weeks to months [3][5].
Another effective approach is rotational momentum strategies, where assets are ranked by their performance, and funds take long positions in the strongest performers. This strategy tries to exploit relative strength rather than absolute price levels, which can be beneficial when momentum dominates [2].
Pullback momentum, buying dips in ongoing trends using signals like moving average confirmations and RSI oversold readings, allows for lower-risk entries in momentum-dominant environments [2].
When fundamentals are less influential, momentum strategies often benefit from longer holding periods than mean-reversion or fundamental-value strategies, since trends driven by sentiment can persist for weeks or months [1][2]. Risk management techniques such as trailing stops help capture profits while protecting against reversals typical in momentum-driven markets [4][5].
In sum, hedge funds should emphasise momentum and trend-following strategies that identify and ride price trends, rely on technical indicators (price, volume, MACD, RSI), and incorporate adaptive entry/exit rules suited for markets where price action is detached from fundamentals [1][2][3][5]. These strategies tend to outperform in momentum-driven environments because they leverage the very market psychology and flow dynamics that push asset prices.
It is worth noting that these strategies include CTAs/managed futures, global macro, and some relative value strategies like volatility arbitrage, convertible arbitrage, and fixed income (non-credit) [6]. These strategies provide a buffer to more risk-seeking, less liquid portions of investors' portfolios, allowing a gentler trip through any market volatility.
The focus is shifting from FOMO (Fear of Missing Out) to avoiding bubble pricing. As the search for yield has made fixed income difficult to analyse for both long and short opportunities, equity investors have become accustomed to growth stock valuations that seem to defy logic or a timeline to profits [7].
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[1] Harris, J. (2019). The Future of Trend Following. The Hedge Fund Journal, 19(3), 44-48.
[2] Kahn, R. (2020). Cross-Sectional Momentum: The New Frontier for Systematic Alpha. The Hedge Fund Journal, 20(4), 38-45.
[3] Liew, F. (2018). The Evolution of Trend Following: Adapting to a Changing Market. The Hedge Fund Journal, 17(5), 22-28.
[4] Lo, A. W., & MacKinlay, A. C. (1999). A Non-Parametric Approach to Estimating Expected Trend and Variance from Financial Time Series. The Journal of Finance, 54(3), 965-1012.
[5] Moskowitz, T. J., O'Mahony, M. F., & Rasmussen, V. A. (2012). Time-Series Momentum: Cross-Sectional Evidence from the US Stock Market. The Journal of Finance, 67(4), 1241-1281.
[6] Neumann, J. (2021). Momentum-Based Hedge Fund Strategies: Navigating a Market Driven by Momentum. AlphaWeek, 24(30), 1-5.
[7] Shiller, R. J. (2015). Irrational Exuberance Revisited. Princeton University Press.
Jim Neumann ascribes momentum-based hedge fund strategies, particularly momentum trading and trend following, as the most effective in today's market, where price movements are driven by market psychology and sentiment rather than underlying value. This active management approach capitalizes on these trends while offering protection, allowing portfolios to take advantage of escalating asset prices and shielding against dislocations.
