Trend Following
By: Ben Mcdonald
Tags: Trend Following, Portfolio Management, Investing, Equity, Risk Management

Let’s run a simple backtest. If equity markets are higher than they were 12 months ago, we own stocks for the next month (in this case, US large-cap equities). If stocks are negative year over year, we will own bonds for the next month (in this case, 5 year US Treasuries). We’ll call this strategy “Trend Following”. We will use data going back to January 1948 and we’ll compare our simple strategy versus an all Equity portfolio. Surely an all Equity portfolio would outperform a portfolio that switches between the same equities and lower returning bonds, right?

Wrong! Trend Following actually outperformed all Equity just barely, earning an annualized 11.55% versus 11.50%. You probably wouldn’t have guessed that unless you’ve seen it before.

But that’s not even the important part. The kicker is that Trend did so while taking on way less risk. The standard deviation was 11.7% for Trend and 14.2% for equity. The downside deviation was 8.6% versus 9.9%. The maximum drawdown of Trend was -29.5% versus -50.9% for Equity. Here’s what the drawdowns look like for each strategy.

You can see that Trend Following really helped avoid the major drawdowns, although every now and then it was worse than Equity for smaller drawdowns. Regardless, you can see that Trend Following has helped mitigate risk without sacrificing long term returns. You can get a sense for the return profile of Trend versus Equity in the following chart, which shows the distribution of annual returns.

Equity has a big fat left tail which has caused many investors to sell at the absolute worst time. You do give away some of the upside of stocks (this is known as being ‘whipsawed’; switching to bonds right before great equity returns). Regardless, Trend has had a more consistent return profile without giving up long-term returns.

Let’s look at 5 year rolling returns to see when Trend has done well and when it has done poorly.

By and large, when 5 year rolling returns are at the lows, Trend is beating Equity. This is largely due to Trend avoiding that sharp drawdowns we saw above. We know that a 50% loss and a 50% gain does not get you back to square one, so avoiding sharp drawdowns is key.

Another way of looking at this is on a scatter plot, where every dot represents the 5 year performance of Trend and Equity. This is quite a chart. You can see that when Equity performs poorly (dots are on the left side of the x-axis), Trend following outperforms Equity (dots are above the dotted diagonal line). The nice thing is when equities are flying (dots are on the right side of the x-axis), Trend mostly keeps up (dots are near dotted line). This is obviously because when the trend is positive, Trend and Equity are invested in the same thing.

The Trend Following strategy I laid out above is obviously simplistic and not something you’d carry out in a client’s portfolios. Clearly you aren’t going to invest your client’s money by going either 100% equities or 100% bonds. Clearly there are tax and transaction considerations. That doesn’t mean it’s useless. You could use Trend Following to help make decisions with tactical asset allocation. You could use Trend to help make decisions around deploying large client deposits (if Trend is negative, perhaps you hold off on buying equities or dollar cost average over a long time period).

Trend following is by no means a bulletproof strategy. It can go very long periods of underperformance. That said, if your bar for employing an investment strategy is that it has to work every time, all the time, then you won’t be employing any investment strategies. Like valuations, trends can help make decision-making but are no panacea.

There are many theories as to why trend following works. There are behavioural ones, such as humans underreact to fundamentals and tend to herd into recent past performers. There are also structural ones, such as it takes investment teams and committees a while to shift portfolios into assets that are expected to perform well in the coming years.

Regardless, if history is any indication, the trend is your friend.