Practical Trend-Following (Part 2)

In part 1 of this article, we looked in the historical context to see if trend-following strategies might have worked. In part 2 of this article, we will try to see why trend-following strategy might have worked.

Samuel Lee 19.03.2015
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Why would such a silly-sounding strategy work? Its big payoffs occurred after episodes of speculative mania in the 20s, the 60s, the 90s, and the 2000s. When the market is booming, investors tend to borrow money to buy financial assets and spend a lot because they feel rich. Their actions cause asset prices and incomes to rise. Lenders see this and think borrowers are more creditworthy, so they extend even more credit, kicking off another round of asset purchases and spending. The cycle feeds on itself and can go on for a long time. As leverage builds up, the financial system becomes more fragile. At some point, a shock to markets bankrupts the most-leveraged investors and forces them to liquidate their assets. Forced selling depresses prices further, bankrupting more-leveraged investors. Lenders withdraw credit, inducing more forced selling. Panic sets in. Because a disproportionate amount of capital is controlled by leveraged investors, unleveraged investors can’t step in to stop markets from going into a free fall. Eventually, prices bottom at depressed levels.

 

In other words, trend-following probably works because of the way our credit-based financial system interacts with human nature. Investors, bankers, and policymakers fail to appreciate the explosive potential of systemic leverage because they base their assessments of risk on personal experience and recent history.

 

Unfortunately, trend-following can generate lots of turnover. On average, our simple strategy generated a trade every 10 months, implying an average turnover of 120%. This is too high. A buffer rule makes sense. Say the 12-month moving average of an asset’s price is 100, but its month-end price is 99.8. The simple strategy would be to sell the asset. Chances are good that a random hiccup would trigger a buy signal the next month. A buffer rule reduces whipsaws by having the strategy maintain its current position as long as the price is within a buffer zone around the trend line.

 

Exhibit 4 shows the returns and turnover of various buffer rules. The first is with no buffer. The next three use symmetric buffers around the moving average, meaning that if the asset’s price is within X percent of the moving average, the current position is maintained. The next three apply buffers below the moving average. When the market dips a little below the trend line, the strategy won’t trigger a sale, but as soon as it breaks above the trend line it will trigger a buy. The last three trigger sales as soon as the price breaks below the trend line but applies a buffer when prices go a little above it.

 

The downside buffer works best, slightly enhancing returns and cutting turnover. This makes sense. Sudden dips tend to quickly reverse themselves. Big upside buffers seem to hurt because they force the strategy to sit out recoveries for too long.

 

I wouldn’t read too deeply into the minor return differences among the different rules. The results are skewed by how the buffers would have worked during the Great Depression and the recession of 1937–38. The data suggest modest buffer rules don’t hurt returns, and that downside buffers seem to work better than upside buffers.

 

Even with the buffer rules, the strategy likely would not have been profitable after costs for most of the sample period. The advent of modern financial markets and tax-deferred accounts has changed all that. Many mutual funds don’t impose transaction fees and allow you to buy and sell at net asset value. Exchange-traded funds and futures allow you to pay a few basis points per round trip trade. Tax-deferred accounts allow you to avoid short- and long-term capital gains taxes from churning your portfolio. Further tweaks like aggressive tax-loss harvesting and rules to avoid realizing short-term capital gains could make a trend-following strategy feasible in taxable accounts.

 

 

 

Strategy Diversification and Position Sizing

It doesn’t make sense to apply trend-following rules to all your assets. I’ve long preached the virtues of strategy diversification. As I pointed out earlier, trend-following subjects you to some nasty tracking error that can persist for years or even decades. While tracking error is emotionally draining, it’s necessary for the strategy to work. If you could consistently outperform the market with simple back-tested rules, money would pile in and arbitrage away its profits. From this perspective, trend-following’s stench of disreputability and unconventionality is a blessing, scaring big institutions from using it.

 

Of course, we can’t dismiss the possibility the strategy becomes too popular. This may have happened in the early 1980s, when trend-following strategies under the scientific guise of portfolio insurance came into vogue. Institutions engaged in the strategy may have caused or exacerbated Black Monday, Oct. 19, 1987, when the Dow Jones Industrial average dropped almost 23%. If you squint, you can see in Exhibit 2 in Part 1 that from 1987-end to 1990-end, the strategy lagged the market by a cumulative 25%. Future markets could be characterized by big, sharp reversals, which would devastate trend-followers. I would hedge against this possibility by applying trend-following signals to only a portion of your assets.

 

 

Samuel Lee is a strategist covering passive strategies on Morningstar’s manager research team and editor of Morningstar ETFInvestor, a monthly investment newsletter

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Samuel Lee  Samuel Lee is an ETF strategist with Morningstar and editor of Morningstar ETFInvestor

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