Investing as a World View: 

Convergent versus Divergent Trading 

Dr. Mark S. Rzepczynski, John W. Henry & Company, Inc. 

  

The volatile performance of hedge funds and, in fact, all money managers in the last year suggest that the process of return generation by managers is quite complex. Strategy, style and ultimately performance are fundamentally linked with how managers view return behavior in their market specialty and around the world. A "world view" of return behavior is a manager's theoretical and empirical view of how market prices behave and how world events effect price linkages across markets. These assumptions determine the strategy and tactics employed by a manager and provide insight for why and when managers will generate returns.
A world view fundamentally addresses the question, "Are financial markets and the world stable?" How managers generate returns is founded on their beliefs of stability, stationarity, and the speed of adjustment process of prices. Specifically, return generation and trading behavior can be classified by a manager's views concerning convergence or divergence in price. A convergent trading philosophy believes that there are stable price relationships that can be statistically measured and exploited. This is a fundamentalist view of the world. Deviations from normal relationships can be exploited because prices out of line will move back or converge to a mean or theoretical value. 
A divergent world view believes that stable relationships may always exist or may only exist in the very long-run. There can be significant divergences from believed or perceived theoretical and statistical relationships that can be profitably exploited through following trends in the price adjustment process. Fundamental models generally explain only a small portion of the variation in asset prices; consequently, they may have limited value in generating returns in a volatile and uncertain world.
By understanding a manager's price behavior framework, whether convergent or divergent, investors can discriminate between a manager's unique world view of risks. Investors can introduce an alternative level of diversification by holding managers that have different views of market price dynamics. For example, where is the diversification with holding three arbitrage managers? Investing, however, with both divergent and convergent managers should provide returns in stable markets that are appropriate for convergent trading and good returns during periods of market instability when markets diverge.

  

Convergent trading failed in 1998
Many arbitrage hedge funds served as the poster children for one type of world price view. Return generation through arbitrage trading is based on a statistical world of convergence. Convergence trading assumes that the world is stable and stationary, and measurable deviations from knowable equilibrium values are limited in time and degree. Profits are derived because markets, "out of line" from some equilibrium value, will reverse or move back to some fair value. Markets which have a knowable or inherent equilibrium, albeit somewhat difficult to extract, can be exploited. Since these relationships are considered stable and by definition deviations are small relative to overall market direction, leverage can and must be used liberally to generate a meaningful return on equity. If there is greater disagreement about fair value, there is more potential for profit, but the risk of mistakes is greater. Clearly, the world is not random, so this type of strategy can be profitable when effectively employed. The problem arises when the believed stable relationship changes. If the mean difference changes between two markets, there is potential for error because it takes time to gather data and learn the new equilibrium. Maintaining the status quo is dangerous. 
This stable view of the world failed miserably in 1998. With convergence trades, based on perceived extremes, initial losses may actually create the perception of more opportunity. If a trade were based on a two standard deviation event, it would seem that the probability of success increases if prices move to a three standard deviation event. There was a mistaken belief that because the probability of success may actually increase, trade exposure should be increased. For last year, stable "arbitrageable" relationships that were taken as given were reversed. There was a reversal of price convergence in Europe, emerging markets, mortgages, and credit markets. The world was neither calm nor stable. Under this environment, an alternative world view may be more effective and provide diversification.
 
 A divergent view was successful 
Opposite of the stable and stationary world view are divergent traders such as trend-following commodity trading advisors (CTAs) that saw better returns last year than most convergence managers especially in the disruptive third quarter. In a trend-follower’s world, especially for those looking for trends that last for extended periods, markets are generally believed not to be convergent but rather a place of constant change and disruptive divergences. By their very nature, trends move away from the norm or the current empirical relationships. Disruptive shocks do occur and lead to trending as investors adjust to new equilibrium prices. In 1998, disruptive shocks, to name a few, were caused by a change in regime such as the introduction of the euro, a change in central bank behavior, the continued Asian crisis, and the long-term decline of Japan.
Inherent in any of these disruptive events was an uncertainty of their immediate meaning on market prices, which caused investors to make mistakes in judgment and perceptions of the events. Changes in equilibrium coupled with high uncertainty will lead to a slower adjustment in prices that effectively plays to the strength of trend-followers.
In a divergent world view, there is no inherent belief that markets will reverse direction or move to a stable long-run equilibrium, rather the world adjusts over time to new equilibrium prices. An equilibrium price may exist, but it is not easily knowable. Accepting fallibility at being able to determine far value, the divergent trader believes that current price direction and momentum are the best indicators of future prices. Markets may converge, in fact, most market do converge, but there is no reason why a market will revert to some mean from a sample of only a few years of data. The greatest risks and opportunities are with those few markets in any year where there are divergences and prices do not follow a historical relationship. 
Does the divergent trader know what that new equilibrium price will be? Probably not. Who can predict the future? The world is constantly changing and new relationships are developing. There are limitations with trying to understand all of the models of the world markets. There are nonrecurring events that may not follow traditional behavior. In addition, even if forecasters could get the direction right for changes in asset markets, it is unclear whether there is any consensus on the magnitude of change. Market instability leads to uncertainty and volatility and may potentially produce the greatest opportunities. Under this uncertain world, markets cannot adjust immediately and hence form trends. It takes time for the managers who live in and accept a convergent world to change their behavior. It is often easier to explain away the events that do not fit our assessment of the facts than to accept a change in market relationships.
This divergent world view will have significant impact on the return profile of trend-followers and how they approach risk. Because a trend may not always materialize tight stop loss risk management techniques are employed. If the trend does not materialize, get out. There is no second-guessing the market. The manager does not inherently believe that he has superior information or ability to assess news. Accepting that divergences are not the norm means that the trend-following manager will not have the same return profile as a convergence manager.
 
Investment styles based on view of market stability
Current world economic conditions caused the success of divergent trading relative to convergent trading. Many of the events that have driven returns in the last year have all been divergences from the norm. Some of these events caused small divergences other had larger consequences. Its is difficult, a priori, to determine which will cause the most readjustment of prices. Hence, it is worthwhile to diversify world views.
"World events" affect the stability of market price relationships. If the world is an unstable place, which constantly faces the unexpected, an investor should be predisposed to some divergent trading as a form of protection against their normal portfolio holdings. If a fund manager believes the world is inherently stable, then trading should be based on short-lived shocks that will quickly reverse to a well-defined norm. With strong world growth, increasing credit quality, and continued capital market integration, convergent trading was extremely successful for the last five years. However, those who had been lulled into a false sense of security were especially hurt last year when the calm environment changed. Unfortunately, through limiting statistical samples or assuming away extremes as outliers or one-time events, managers sometimes systematically forget what is often the most important information for return generation. Perhaps, there may be a "boom in busts" around the world, or more aptly, the unexpected is more commonplace.
Most styles of investing, whether explicitly or implicitly, can be classified by a statistical or stability view of the world. In fact, all trading strategies fall into these two types. For example, value equity investing is a form of convergence trading while growth or momentum trading is a divergent style. Generally, the return profile of convergent traders will be a fairly tight distribution with a negative skew associated with those events that create divergences. Divergent traders will have higher volatility, but a positive skew associated with profits from extreme trends and stop losses that cut risks.
The degree of belief concerning each of these world views affects the behavior of an asset manager. Diversification would argue that there is a need for both types of trading styles. Trend-following CTAs with a focus on divergent trading and some convergent trading funds can span the set of world views and allow for return potential in all price environments.
 
This reprint does not constitute an offer to sell or a solicitation for any managed account and cannot disclose all risks and significant elements of the JWH investment programs. Solicitations can only be made with a JWH disclosure document, which is available at the offices of JWH upon request.  Further details of past performance and definitions of terms used to state past performance are presented in the disclosure document. 

Although offering potential benefits, an investment with JWH is speculative, involves a high degree of risk, and is designed only for sophisticated investors who are able to bear the loss of more than their entire investment.  Some, but not all, of the risk factors that should be considered prior to making an investment decision include:  forward contract trading, which is not afforded the regulatory protection of exchanges or the Commodity Exchange Act and may subject an investor to greater risks than trading on U.S. exchanges; trading on non-U.S. futures exchanges, which are not regulated by any U.S. government agency and may involve certain risks not applicable to trading on U.S. exchanges; currency risks associated with foreign-denominated margin deposits; possible failure of brokerage firms or futures exchanges; and illiquid markets, which may make it more difficult to establish or liquidate a position at a given price.  For more details on these and other risk factors, please refer to JWH's current disclosure document. 

PAST PERFORMANCE IS NOT NECESSARILY INDICATIVE OF FUTURE RESULTS 

 
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