Swedroe: Why Financial Trends Persist

March 19, 2018

Long-Running Trend

Hurst, Ooi and Pedersen continued: “The fact that trend-following strategies have performed well historically indicates that these behavioral biases and non-profit-seeking market participants have likely existed for a long time.”

Why would this be the case? They explain: “The intuition is that most bear markets have historically occurred gradually over several months, rather than abruptly over a few days, which allows trend followers an opportunity to position themselves short after the initial market decline and profit from continued market declines…. In fact, the average peak-to-trough drawdown length of the 10 largest drawdowns of a 60% stocks/40 bonds portfolio between 1880 and 2016 was approximately 15 months.”

They noted that trend-following has done particularly well in extreme up or down years for the stock market. In fact, they found that during the 10 largest drawdowns experienced by the traditional 60/40 portfolio over the past 135 years, the time-series momentum strategy experienced positive returns in eight of these stress periods and delivered significant positive returns during a number of these events.

While Hurst, Ooi and Pedersen provided results that included a 2/20 fee structure, today there are funds that can be accessed with much lower, although still not exactly cheap, expense ratios. An example is AQR’s Managed Futures Strategy (AQMRX), which has an expense ratio of 1.15%.* (Full disclosure: My firm, Buckingham Strategic Wealth, recommends AQR funds in constructing client portfolios.)

Additionally, AQR has found that, in implementing time-series momentum strategies, their actual trading costs have been only about one-sixth of the study’s estimates used for much of the sample period (1880 through 1992), and approximately one-half of the estimates used for the later period from 1993 through 2002.

Summary

As an investment style, trend-following has existed for a long time. Data from recent research provides strong out-of-sample evidence, beyond the substantial evidence that already existed in the literature. It also provides consistent, long-term evidence that trends have been pervasive features of global stock, bond, commodity and currency markets.

Addressing the issue of whether investors should expect trends to continue, the AQR researchers concluded: “The most likely candidates to explain why markets have tended to trend more often than not include investors’ behavioral biases, market frictions, hedging demands, and market interventions by central banks and governments. Such market interventions and hedging programs are still prevalent, and investors are likely to continue to suffer from the same behavioral biases that have influenced price behavior over the past century, setting the stage for trend-following investing going forward.”

The bottom line is that, given the diversification benefit and its downside (tail-risk) hedging properties, a moderate portfolio allocation to trend-following strategies merits consideration. Note, however, the generally high turnover of trend-following strategies renders them relatively tax inefficient. Thus, investors should strongly prefer to hold such strategies in tax-advantaged accounts.

 

*Discussion of AQMRX is provided for informational purposes only and is not intended to serve as specific investment or financial advice. This discussion does not constitute a recommendation to purchase a single specific security, and it should not be assumed that the security referenced herein was or will prove to be profitable. Prior to making any investment, an investor should carefully consider the fund’s risks and investment objectives and evaluate all offering materials and other documents associated with the investment.

 

Larry Swedroe is the director of research for The BAM Alliance, a community of more than 140 independent registered investment advisors throughout the country.

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