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EXPERT OPINION

Trend followers take positions in markets solely based on observable price trends. However, identifying trends is not enough. The allocation model and its ability to sufficiently diversify a portfolio are a prerequisite for success of a trend follower. In the long term, trend followers stand out for their decorrelation from the major market indices, which makes them a highly effective portfolio management tool. Let’s take a step back and better understand trend-following investment philosophy and how they add value.

TREND-FOLLOWING STRATEGIES LEVERAGE MARKET DIRECTIONALITY

Trend-following strategies are commonly referred to as Commodity Trading Advisors, or CTAs. They exploit a market anomaly whereby prices that go up tend to keep going up and vice versa (see Fig 1). This phenomenon is also referred to as the “momentum effect”.

18

14

09/2012 03/2013 12/2013

16

12

06/201312/2012 09/2013

8 months u

p trend

5 months down trend

Market directionality can be exploited via futures contracts. They allow investors to benefit from both positive and negative price dynamic, as futures contracts allow them to take either long or short positions.In seeking to derive value from trends, trend-following strategies do not play the same game as strategies driven by fundamentals. Typically, trend-following strategies follow a well-defined quantitative investment process without any discretionary portfolio manager intervention. Such a process means that CTAs

Source: Bloomberg, Lyxor analysis. Data as at 31/03/2016

Fig 1: Futures prices of USD versus JPY

allow the avoidance of behavioural biases from which portfolio managers may suffer as they are agnostic about the fair value of an asset. Their model identify trends as early in their development as possible: they undertake a correct statistical and factor analysis of price dynamics (based on past returns, volatilities and correlations) while filtering out noise. Their quantitative process allows for diversification over a broad investment universe without requiring a large team of analysts specialising in each particular asset class and geographic region.

>> TREND FOLLOWING STRATEGIES

>> Trend Following Strategies initially mainly invested in commodity futures, hence their name Commodity Trading Advisors

>> The origin of exchange traded commodity futures goes back to 1848 when the Chicago Board of Trade was founded

>> The trading spectrum of CTAs broadened in the 1970s and 1980s when futures on currencies, interest rates, bonds and stocks became widely available

>> According to the HFR Global Hedge Fund Industry Report Q3 2015, the assets under management for CTAs has grown from less than $10 billion in 1990 to more than $250 billion in 2015

Guillaume Jamet, Principal fund manager of the Lyxor Epsilon systematic trend programme

DIVERSIFICATION WHEN YOU NEED IT MOST

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EXPERT OPINION

15%

5%

-5%

Position built-up following positive price trend

Position wind-down following reverting price trend

CTA EXPOSURE

jan jul octapr Dec

20

0

10

-10

Positive P&L impact from position

Limited losses due to wind-down

CTA P&L IMPACT

jan jul octapr Dec

110

130

90

FUTURES PRICE OF GOLD5 months down trend8 months up trend

jan jul octapr Dec

Past performance is no guarantee of future results. It is not a reliable indicator of future results.Source: Bloomberg, Lyxor. Data as at 31/12/2011

Fig 2: Example of how a CTA could trade on the evolution of gold futures prices (2011).

The momentum effect is a market anomaly that has been around for a long time. Research from the Norwegian central bank shows its existence for a broad set of asset classes with data going back to 19601.

Extensive academic research has been conducted to explain the momentum effect anomaly. The following root causes are often identified2:

>> Behavioural finance-related criteria, such as herding. Herding refers to the tendency of investors to mimic the decisions of their peers

>> Delays by market participants in adjusting positions following price variations

>> Delays in information assimilation

Thanks to their use of futures contracts, trend-following strategies are virtually free of counterparty risk and are highly liquid. They are able to rapidly adjust their positions in case of changes in market circumstances, as illustrated in figure 3.

Since 2008, trend-following strategies have been increasingly offered via UCITS-compliant wrappers, making them available to a larger investor base.

1 See NBIM Discussion Note: Momentum in Futures Market, 20142 See e.g., Chan L.K.C., Jegadeesh N. and Lakonishok J. (1996), Momentum Strategies, Journal of Finance, 51(5), pp. 1681-1713

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EXPERT OPINION

CTA Net expo to Equities (% NAV)

MSCI World (net total return, USD)

-50

-30

-10

10

30

50

70

90

110

85

90

95

100

105

110

115

Jan -15 Apr -15 Jul -15 Oct -15 Jan -16 Jan -15 Apr -15 Jul -15 Oct -15 Jan -16

CTA Net expo to Energy (% NAV)

WTI (USD/ b)

-14

-12

-10

-8

-6

-4

-2

0

2

4

20

25

30

35

404550

55

60

65

Source: Bloomberg, Lyxor. Data as at 29/03/2016

Fig 3: Exposure to equities and to energy for CTAs listed on the Lyxor Managed Account Platform.

TREND-FOLLOWING STRATEGIES OFFER PERFORMANCE AND DE-CORRELATION

Trend-following strategies offer two main advantages: performance and portfolio de-correlation.

Performance

By determining the statistical features of the behaviour of each market (e.g. volatility, correlation, average return, etc.) that are likely to indicate a trend, trend-following strategies can disregard the fundamental approach. Such a systematic approach, which does not require an in-depth knowledge of each market, enables them to expose the portfolio to a large number of markets at the same time. This results in an investment strategy with an unparalleled degree of diversification capable of generating returns in both bearish and bullish market conditions if trends are present.

The SG Trend Index3, a performance indicator for the trend-following strategy sector, generated 6.5% annually since inception in 2000, clearly outperforming equities and bonds. Performance was particularly strong during the dot-com bubble and the credit crisis.

$3 000

$2 000

$1 000

$0

SG Trend index

Global bonds

Global equities

DOT-COM BUBBLE

CREDIT CRISIS

2000 2002 2004 2006 2008 2010 2012 2014 2016

Fig 4: Evolution of an initial USD 1,000 investment

Past performance is no guarantee of future results. It is not a reliable indicator of future results.Source: Bloomberg, Lyxor analysis, data as at 31/03/2016

3 The SG Trend Index is designed to track the 10 largest (by AUM) trend-following CTAs. The SG Trend Index is equally weighted, and rebalanced and reconstituted annually.

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Difference,%

97.3

76.2

16.0

43.9

MSCI WORLD 4 LARGEST DRAWDOWNS SINCE SEPTEMBER 1997

Periods Performance

-59.1%

-51.4%

-22.8%

-20.5%

38.3%

24.8%

-6.8%

23.3%

31-Oct-079-Mar-09

27-Mar-009-Oct-02

2-May-114-Oct-11

20-Jul-985-Oct-98

Past performance is no guarantee of future results; it should not be assumed that the performance of the fund in the future will be comparable to the performance information presented here.Source: Bloomberg, Lyxor analysis. Data relate to the period September from 1997 – March 2016

Portfolio de-correlation

For many reasons, trend following offers true diversification opportunities to investors:

>> The strategy is intrinsically diversified: as it focuses on price data, it is a systematic generalist playground and all markets can be reached in a single portfolio.

>> Correlation between trend-following strategies and traditional asset classes is very low over the long run, thanks to their purely systematic approach. As illustrated in figure 5, the correlation between the SG Trend Index and equities is -0.14, while with bonds this is 0.24. Consequently, adding a CTA to an investment portfolio with traditional investments can significantly improve its risk/return characteristics.

0.24

-0.14

Equities: S&P500 Total Return Index

Bonds: Barclays Aggregate Total Return Index Value Hedged USD

Fig 5: Correlation between the SG Trend Index and:

Past performance is no guarantee of future results. It is not a reliable indicator of future results.Source: Bloomberg, Lyxor analysis. Correlations have been calculated for the period from February 2000 – February 2016

>> Trend-following strategies tend to do particularly well in periods of crisis as many asset classes show clear trends. Thanks to this “crisis alpha”, trend-following strategies offer diversification when investors need it most. This is illustrated in figure 6 which features the performance of the Lyxor Epsilon Managed Futures fund during periods of large equity draw downs. During each of these periods, the fund outperformed the MSCI World Index. During 7 out of the 10 months with the worst MSCI World performance, the Lyxor Epsilon Managed Futures fund recorded a positive performance, reaching up to 8.0%. During 3 out of the 4 periods with the worst MSCI World draw downs, Epsilon posted a positive performance, achieving up to 38.3%.

Months PerformanceDifference,%

-19.0%

-13.5%

-12.1%

-11.1%

-10.5%

-9.9%

-9.0%

-8.9%

-8.8%

-8.8%

4.6%

8.0%

1.9%

7.9%

1.2%

-2.5%

2.1%

4.4%

-2.7%

0.1%

MSCI WORLD 10 WORST MONTHS SINCE SEPTEMBER 1997

MSCI World Epsilon Managed Futures A USD

Oct-0823.7

21.4

14.0

19.0

11.7

7.4

11.1

13.4

6.1

9.0

Aug-98

Sep-08

Sep-02

Feb-09

May-10

May-12

Sep-01

Sep-11

Jan-09

Fig 6: Performance of the Epsilon Managed Futures fund during periods of equity draw downs

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EXPERT OPINION

Figure 7 shows how adding a CTA, represented here by the Lyxor Epsilon Managed Futures fund, to a traditional equity/bond portfolio can improve both returns and risk. By changing the asset allocation from 60% bonds/40% equity to 50% bonds/30% equity/20% Epsilon Managed Futures fund, the annualised rate of return would have been improved from 4.9% to 5.7% and the volatility would have been reduced from 6.7% to 5.7%. The maximum draw down would have been improved from -24.4% to -15.5%.

Fig 7: Effect of adding a trend-following strategy to a mixed equity/bond portfolio.

The figures relating to simulated and past performance refer or relate to past periods and are not a reliable indicator of future results.Source: Bloomberg, Lyxor analysis. Data as at 31/03/2016

Portfolio 1 Portfolio 2 Difference

RETURN

CUMULATIVE 144.5% 186.8% 42.3%

ANNUALIZED 4.9% 5.7% 0.9%

ANNUALIZED VOLATILITY 6.7% 5.7% -1.0%

MAXIMUM DRAWDOWN -24.4% -15.5% 8.9%

SHARPE RATIO 0.39 0.61 0.23

INCLUDING TREND-FOLLOWING STRATEGIES IN A LONG-TERM STRATEGIC ASSET ALLOCATION

The question whether there is an ideal moment to invest in (or exit) CTAs often arises. Predicting such timing turns out to be difficult even impossible as CTAs feature an asymmetric return distribution. Most of the time, they generate small losses, while “seeking” trends. Only during a short period of time returns are positive but tend to be very strong, largely outweighing losses. As these periods of positive return are typically short, investors should already be invested upfront. Therefore, we recommend that investors include trend-following strategies as part of their long-term strategic asset allocation, rather than timing entry or exit moments. This is shown in figure 8, where the performance of Lyxor Epsilon Global Trend is illustrated.

In unfavourable environments, it is important for investors to hold on to their investments; history shows that over a full cycle, the environment will become favourable again. However, the timing of this change is difficult to predict.

The figures relating to simulated and past performance refer or relate to past periods and are not a reliable indicator of future results.Source: Bloomberg, Lyxor analysis. Data as at 31/03/2016

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06/15 09/15 11/15 01/16

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10/1508/1507/15 12/15 02/16

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Fig 8: Performance of Epsilon Global Trend, June 2015 – February 2016

250%

200%

150%

100%

50%

1997 2006 20090

2003 20152012

Portfolio 1 : 60% bonds, 40% equity

Portfolio 2 : 50% bonds, 30% equity, 20% Epsilon Managed Futures

2000

CUMULATIVE RETURN KEY METRICS

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Indeed, on an ex-post basis, we can explain why during certain periods CTAs, on average, performed better than in other periods. In order to do so, we will use two proprietary indices, developed by Lyxor.

Two factors are important for CTAs to generate performance:

1. Markets need to show trends. We measure this via the Lyxor Epsilon Trend Index, which calculates the average strength of trends on the financial markets on a 1-year rolling basis. A high measure means that markets have been characterised by high directionality, either downward or upward.

2. Returns between asset classes should have low correlations, to allow the fund to diversify over a large number of asset classes. We measure this via the Lyxor Epsilon Correlation Index, which calculates the correlation between markets on a 1-year rolling basis.

As can be seen from the following figure, 2011 and 2012 were years where both conditions were not met: markets were “rangy”, going up and down without clear trends. Correlations between asset class returns were high. As a result, many trend-following funds did not perform well. The SG Trend Index returned -7.9% in 2011 and -3.5% in 2012. Circumstances improved in 2014 with a growing presence of trends and reduced correlations between asset classes. As a result, the SG Trend Index returned 19.7% in that year.

20%

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-20%

2004 2009 2011 2013-30%

201020082007 20142012 2016201520062005

30%

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45%

Lyxor Epsilon Trend Index Lyxor Epsilon Correlation Index

Favorable environment

Unfavorable environment

Favorable environment

Fig 9: Effect of market trendiness and correlations on CTA performance

Source: Lyxor. Data as at 31/03/2016The purpose of the two proprietary indices is to analyse some of the drivers of the average past performance of trend-following strategies. It gives no indication of future results.

2.7% 0.8% 8.2% 8.6% 20.9% -4.8% 13.1% -7.9% -3.5% 2.7% 19.7% 0.0%

CONCLUSION

Trend-following strategies leverage on the existence of the “momentum effect” anomaly. Due to their return profile and de-correlating characteristics, they may offer significant value to an investor’s portfolio. They may improve return and reduce risk, especially in times of crisis.

Performance of SG Trend Index

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EXPERT OPINION

Epsilon Managed Futures

Epsilon Global Trend SG Trend index

Inception 1997 2011 2000

Annualised return

Since inception 8.3% 3.9% 6.6%

10 years 8.4% - 5.3%

3 years 12.4% 11.1% 6.9%

1 year -9.2% -1.7% -4.1%

Investment universe More than 60 futures in equities, rates, currencies and

commodities

Same as Epsilon Managed Futures, but excludes com-

modities

-

Structure AIF fund UCITS fund Index

Annual target volatility 15% 10% -

Liquidity Daily -

Fees (institutional share classes)

1% management fee15% performance fees

High water mark

-

This material and its content are confidential and may not be reproduced or provided to others without the express written permission of  Lyxor Asset Management (“Lyxor AM”). This material has been prepared solely for informational purposes only and it is not intended to be and should not be considered as an offer, or a solicitation of an offer, or an invitation or a personal recommendation to buy or sell participating shares in any Lyxor Fund, or any security or financial instrument, or to participate in any investment strategy, directly or indirectly. It is intended for use only by those recipients to whom it is made directly available by Lyxor AM. Lyxor AM will not treat recipients of this material as its clients by virtue of their receiving this material. This material reflects the views and opinions of the individual authors at this date and in no way the official position or advices of any kind of these authors or of Lyxor AM and thus does not engage the responsibility of Lyxor AM nor of any of its officers or employees. Services and marks appearing herein are the exclusive property of SG and its affiliates, as the case may be. Services and marks appearing herein are the exclusive property of Lyxor AM and its affiliates, as the case may be.

LYXOR EPSILON PROGRAMME

The Epsilon programme has been launched in 1994. The oldest fund currently in place is Epsilon Managed Futures, launched in 1997. Since inception of the programme, the fund management team has continuously invested into research and development of the model, systems and infrastructure in order to stay at the forefront of innovation and to adapt to evolving market circumstances. Epsilon is a pure trend-following strategy, without any discretionary portfolio manager intervention. The programme currently features two funds, with the possibility of creating dedicated mandates.

Past performance is no guarantee of future results. It is not a reliable indicator of future results.Source: Bloomberg. Data as at 31/03/2016

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EXPERT OPINION