Swedroe: Trend Following As Insurance

May 13, 2019

Missing Out

Missing out on returns is inevitable due to the nature of trend following. For the strategy to work successfully, there needs to be a clear trend—either positive or negative. Unfortunately, because the strategy needs that strong trend signal to form before investing, it will naturally keep investors on the sidelines, which means sacrificing some returns.

If investing in trend following means you are guaranteed to miss out on some returns, why invest in the strategy at all? Didn’t we just demonstrate that trend following significantly underperformed in virtually all major asset classes?

While looking at the last 10 years of data is useful, it is important to note that this time period does not include any prolonged drawdowns. If we extend the time frame examined by just one year to include the bear market of 2008, the results look drastically different. In Vogel’s charts below, we see that the performance of trend following in each asset class improves greatly once 2008 is included in the analysis.



When you examine the data through the lens of maximum drawdown, the value of trend following becomes clear. In the chart above, you can see that trend following has produced significantly better returns from a maximum drawdown perspective in each asset class with the exception of U.S. Treasuries.

Key Takeaways

There are two important takeaways from Vogel’s analysis. The first is that a key to successful investing is to have the discipline to adhere to a well-thought-out plan and not fall prey to tracking-error regret. The other is to remember that an investment strategy should not be judged solely by its performance. One must also consider what alternative universes might have shown up!

Vogel’s analysis showed the importance of looking at data over long periods and across full market cycles. Andrew Clare, James Seaton, Peter Smith and Steve Thomas, authors of the April 2019 study “Absolute Momentum, Sustainable Withdrawal Rates and Glidepath Investing in US Retirement Portfolios From 1925,” examined the benefits of trend following over the period 1927 through 2016.

To test the performance of absolute momentum, they used a simple 10-month trend-following rule. In the case of stocks and bonds, they are in an uptrend if the price is above the 10-month moving average and thus a long position is held. If the price is below the moving average, the weighted funds are assumed to be invested in T-bills instead.

They examined sustainable withdrawals by focusing on perfect withdrawal rates (PWR)—the maximum annual withdrawal rate possible if one had perfect foresight of returns and ran one’s wealth down to zero at the end of the period. They also ran Monte Carlo simulations (MCS) using the same PWR analysis.

MCS provides several benefits. First, it isn’t dependent on a limited history of capital market returns. Second, it allows you to consider a potentially unlimited number of trials, examining results from “alternative universes.” A third benefit is that MCS allows you to alter capital market assumptions.

Following is a summary of the authors’ findings:

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