Finding value when the trend fades: convexity in uncertain times

The hedging of high-risk regimes has always been paramount to portfolio construction. Although diversification – particularly for multi-asset portfolio managers – helps mitigate specific risks, directional portfolios remain exposed to sharp drawdowns in high risk environments when assets re-correlate across asset classes.

In these extreme scenarios, solutions are well known: macro-timing, trend following and long volatility exposure may act as tail hedges. Regimes of high economic uncertainty – the situation we seem to be in at present – when returns are less informative about future trends, have attracted far less attention. This excerpt from our Q2 Simply put considers how to find the right systematic strategy for such periods, using history as a guide to 2025.

Read also: Multi asset: investing in a period of tariff-induced uncertainty

Known knowns – the convexity of trend following

Risk must be distinguished from uncertainty. In adverse regimes, the situation is often crystal-clear: prices are falling, volatility is rising and macroeconomic conditions are deteriorating. High-risk regimes, therefore, come with a set of relatively strong signposts that are usually hard to ignore. When such signals are flashing, it does not necessarily mean the risk-off sentiment will be sustained (as happened in August 2024), but risk-off periods tend to come with stable markers. Similarly, low-risk regimes often also coincide with low levels of uncertainty. Figure 1 presents the excess Sharpe ratios¹ of cross-asset strategies – long-short portfolios built on various instruments across traditional asset classes – in different risk regimes measured by different monthly VIX quantiles.  

FIG 1. Excess Sharpe ratio of cross-asset strategies in different risk regimes²

Unsurprisingly, the trend following strategy exhibits its usual convex profile, performing better in well-identified regimes when risk is low and markets are trending upwards, or in high-risk regimes when bonds are rallying and risky assets are falling. Similarly, global macro strategies often offer an appealing downside convexity when risks materialise, benefiting from recession or inflation-wary positioning. In contrast, value and carry strategies appear less sensitive to risk regimes, the former being most challenged in a low-risk environment when the cost of being negatively correlated with trend is the highest.  

Unknown unknowns – if not trend, then what?

Although they may be hard to forecast – or even nowcast, high-risk periods are relatively easy to identify ex-post. Uncertainty periods are more elusive and require a more formal definition. In addition, they do not coincide with higher risk periods, for most of the time (as discussed in Figure 1 of Addressing uncertainty through risk-based portfolio management). 

Here, we examine policy-related economic uncertainty – which is certainly relevant to the current situation – by referencing the Index of World Political Uncertainty³. This index is based on three components: the occurrence of topics relating to economic uncertainty in specialised newspapers; the level of uncertainty regarding the path of the US Federal Tax Code; and the dispersion in individual forecasters' predictions from the US Federal Reserve Bank of Philadelphia's Survey. Figure 2 presents the excess Sharpe ratios of the four cross-asset strategies during policy-related periods of economic uncertainty.

FIG 2. Excess Sharpe ratio of cross-asset strategies in different policy-related economic uncertainty regimes⁴

It is noticeable that the trend following strategy is particularly impacted by high economic uncertainty, as price action becomes less predictable. Carry strategies aim to harness returns that are not extracted from the expected price variations, but from expected income. Interestingly, the cross-asset carry strategy presents the highest Sharpe ratio increase in periods of acute policy-related economic uncertainty, proving a good hedge to trend in such environments. Additionally, the cross-asset value strategy presents an appealing U-shape, outperforming in both low- and high-uncertainty regimes, as expensive assets may suffer from profit-taking during periods of uncertainty. Finally, the macro strategy unsurprisingly suffers when macro uncertainty is high as macro regimes are more difficult to infer, while it performs well in low uncertainty environments.  

From this chart, a key conclusion is that mean-reverting strategies, or strategies that do not count on price direction to post returns, such as value and carry, form interesting additions to any global strategy – an important consideration for Q2 2025. In short, macroeconomic uncertainty proves challenging for trend following strategies. Carry and value strategies can help navigate these hazy environments, while the performance of global macro strategies when macroeconomic uncertainty is low can further enhance diversification. Having previously complemented our overlays with a cross-asset value strategy and a global-macro strategy, in addition to having perfected our trend following approach, our current R&D efforts are focused on carry signals.

Simply put, uncertainty calls for a different set of systematic strategies to increase diversification – carry and value could prove helpful.