Swedroe: Trend Following As Insurance

May 13, 2019

Today my colleague Brian Haywood and I look at trend following, also known as “time-series (or absolute) momentum,” which is the tendency of an asset’s recent price trend, either positive or negative, to persist in the near future.

Essentially, trend followers purchase assets that have done well in the recent past and sell/short assets that have done poorly in the recent past. Trend following gives investors tactical market exposure, as the strategy can be long or short an asset. Trend following is most often implemented using futures contracts.

A large body of evidence demonstrates that time-series momentum has provided a premium that has been persistent over long periods of time; pervasive across asset classes (including stocks, bonds, commodities and currencies); robust to various formation periods; is implementable; and has intuitive, behavioral-based explanations of why it persists. For those interested, Andrew Berkin and I present the evidence in “Your Complete Guide to Factor-Based Investing.

Recent Performance

Unfortunately, trend-following strategies have performed very poorly over the past 10 years, leading many investors to ask, “Why should we continue to invest in trend following?” For the answer, we turn to a recent article by Jack Vogel, CIO/CFO at Alpha Architect.

Vogel looked at how trend following has performed in each major asset class versus the appropriate market benchmarks over the past 10 years. In the analysis, the following indices were used to represent the return of that particular asset class:

U.S Stocks: S&P 500

Developed International Stocks: MSCI EAFE

Emerging Market Stocks: MSCI Emerging Markets

Real Estate: REITS

U.S. Government Bonds: U.S. Treasury, 7- and 10-year

Commodities: GSCI Commodity

Cash: 1- and 3-month U.S. Treasury bills


 The returns are compound annual growth rates and are gross of any fees or transaction costs.

To estimate the return of a trend-following strategy, Vogel uses the following two rules to compute a trend-following index:

  1. Moving Average Rule: Current total return price compared to the average of the past 12 months’ total return prices. If current > average, invest in the risk asset. If not, go to cash.
  2. Time-Series Momentum Rule: Compare the total return (TR) of each risk asset to the TR  to cash over the past 12 months. If the TR for the risk asset > TR for cash, invest in the risk asset. If not, go to cash.

The rules are assessed monthly and each strategy carries a 50% weight.

As you can see in the chart above, trend following has significantly underperformed the market benchmark in each asset class, with the exception of commodities. This analysis points out the biggest downside to trend following—investors will inevitably miss out on returns at some point in time, creating the risk of tracking-error regret, which can lead to the abandonment of even well-thought-out plans.

The risk of tracking-error regret is compounded by the fact that most investors believe that when it comes to evaluating a strategy, three years is a long time, five years is a very long time and 10 years is an eternity. However, financial economists know that 10 years can be nothing more than noise. For example, we have three periods of at least 13 years when the market beta premium was negative: 1929-1943; 1966-1981; 2000-2012 (data is from Ken French’s website).

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