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.”
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:
- 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.
- 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).
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.
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:
- Smoothing the returns on individual assets by simple absolute momentum or trend-following techniques is a potent tool to enhance withdrawal rates. For example, for a 60/40 portfolio with a 30-year horizon, the mean PWR increased from 6.2% to 6.6% (a relative increase of 6.5%), and the minimum PWR increased from 3.6% to 4.4% (a relative increase of 22.2%).
- Applying trend following to bonds has a relatively small impact, with returns and volatility being slightly lower.
- Trend following greatly reduces the “left tail” of unfortunate withdrawal rate experiences—the bad luck of a poor sequence of returns early in decumulation. This was true for both stocks and bonds. For example, for the traditional 60/40 portfolio, the maximum real drawdown was 49.2% but was reduced to 27.3% with trend following. For an 80/20 portfolio, the maximum drawdowns were 65.3% and 29.5%, respectively. And for a 20/80 portfolio, the figures were 49.1% and 32.2%, respectively.
- Trend following allows investors to take on a greater weighting in stocks for the same risk or a reduced level of risk for the same asset allocation.
- Diversifying assets over time by switching between an asset and cash in a systematic way is potentially more important for the retirement income experience than diversifying across asset classes.
The authors concluded: “The withdrawal experience from conventional equity/bond portfolios can be substantially enhanced by applying these smoothing techniques, effectively creating a much higher lower bound for withdrawal rates.” Their findings were consistent with those of Andrew Miller, author of the October 2017 study “Using Trend-Following Managed Futures to Increase Expected Withdrawal Rates.”
Miller examined the period 1926 through 2012. He found that, historically, a 4% initial withdrawal rate from a portfolio of 50% stocks and 50% bonds with a 30-year horizon had a failure rate ranging between 0% and 5%, depending on the bond index used.
Using historical data as inputs into a Monte Carlo engine resulted in a 4% initial withdrawal rate failing in approximately 6% of the simulations. With current equity valuations at historically high levels and bond yields at historically low levels, Monte Carlo simulations produce much higher failure rates with a 4% withdrawal rate. Miller examined how replacing 10% of the allocation to bonds with a 10% allocation to trend following, creating a 50/40/10 portfolio, improved outcomes.
Miller’s data series is an equal-weighted combination of a 1-, 3- and 12-month time-series momentum strategy covering 67 individual futures contracts across stocks, bonds, currencies and commodities. In addition, the strategy is managed to a 10% standard deviation target. He found that the diversified managed futures strategy provided diversification benefits (adding a unique source of risk and return) that has historically supported a 0.8% higher safe withdrawal rate.
The evidence shows that while trend-following strategies will tend to lag the market over even long periods (creating the risk of tracking-error regret for impatient investors), they tend to perform best just when their benefits are needed most—in severe market downturns.
Investors looking to protect themselves from severe drawdowns (such as retirees, for whom sequence risk should be a paramount concern) should consider including an allocation to a diversified trend-following strategy, usually in the form of a managed futures fund (such as AQR Managed Futures Strategy Fund), as it has historically provided insurance against tail risks.
Larry Swedroe is the director of research for The BAM Alliance, a community of more than 130 independent registered investment advisors throughout the country.