Swedroe: Why Trend-Following Works

Similar to some better-known factors, such as size and value, time-series momentum historically has demonstrated above-average excess returns. Also called trend momentum, it is measured by a portfolio long assets that have had recent positive returns, and short assets that have had recent negative returns.

Time-series momentum differs from the traditional (cross-sectional) momentum factor, which considers an asset’s recent performance only relative to other assets. The academic evidence suggests that inclusion of a strategy targeting time-series momentum in a portfolio improves the portfolio’s risk-adjusted returns.

Strategies that attempt to capture the return premium offered by time-series momentum are often called “managed futures,” as they take long and short positions in assets via futures markets—ideally in a multitude of futures markets around the globe.

Today I’ll dive into the time-series momentum factor and examine some of its specific qualities, and those that make a managed futures strategy a good portfolio diversifier.

In general, an asset that has low correlation with broad stocks and bonds provides good diversification benefits. Low or near-zero correlation between two assets means there is no relationship in their performance: If Asset A performs above average, it doesn’t tell us anything about Asset B’s expected performance relative to its average.

The addition of a low-correlation asset to a portfolio will, depending on its specific return and volatility properties, improve risk-adjusted returns by increasing the portfolio’s return, reducing the portfolio’s volatility, or both.

Research From AQR

AQR Capital Management’s Brian Hurst, Yao Hua Ooi and Lasse Pedersen contribute to the literature on time-series momentum through their June 2017 paper, “A Century of Evidence on Trend-Following Investing”—an update of their 2014 study.

In it, the authors constructed an equal-weighted combination of one-month, three-month and 12-month time-series momentum strategies for 67 markets across four major asset classes (29 commodities, 11 equity indices, 15 bond markets and 12 currency pairs) from January 1880 to December 2016. The position these one-, three- and 12-month strategies take in each market is determined by assessing the past return in that market over the relevant look-back horizon.

A positive past excess return is considered an “up” trend and leads to a long position; a negative past excess return is considered a “down” trend and leads to a short position.

In addition, each position is sized to target the same amount of volatility, both to provide diversification and to limit portfolio risk from any one market. Positions across the three strategies are aggregated each month and scaled such that the combined portfolio has an annualized ex-ante volatility target of 10%.

Volatility scaling ensures the combined strategy targets a consistent amount of risk over time, regardless of the number of markets that are traded at each point in time. The authors’ results include implementation costs based on estimates of trading costs in the four asset classes. They further assumed management fees of 2% of asset value and 20% of profits, a traditional fee for hedge funds.

Results

Following is a summary of their findings:

• Performance was remarkably consistent over an extended time horizon, one that included the Great Depression, multiple recessions and expansions, multiple wars, stagflation, the global financial crisis of 2008, and periods of rising and falling interest rates.
• Annualized gross returns were 18.0% over the full period, with net returns (after fees) of 11.0%, higher than the return for equities but with approximately half the volatility (an annual standard deviation of 9.7%).
• Net returns were positive in every decade, with the lowest net return, at 4.1%, coming in the period beginning in 1919.
• There was virtually no correlation to either stocks or bonds. Thus, the strategy provides a strong diversification benefit. After considering all costs and the 2/20 hedge fund fee, the Sharpe ratio was 0.76. Thus, even if future returns are not as strong, the diversification benefits would justify an allocation to the strategy.

Hurst, Ooi and Pedersen write that “a large body of research has shown that price trends exist in part due to long-standing behavioral biases exhibited by investors, such as anchoring and herding [and I would add to that list the disposition effect and confirmation bias], as well as the trading activity of non-profit-seeking participants, such as central banks and corporate hedging programs.”

They observe, for instance, that “when central banks intervene to reduce currency and interest-rate volatility, they slow down the rate at which information is incorporated into prices, thus creating trends.”

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, including the most recent global financial crisis of 2008. 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%. The fund targets volatility of 10%. AQR also has a high-volatility version of the fund, QMHRX, which has an expense ratio of 1.58% and targets volatility of 15%. Thus, it’s slightly cheaper on a pro-rata basis. (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 more recent period (1993 through 2002).

Summary

As an investment style, trend-following has existed for a long time. The data from the 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 the downside (tail-risk) hedging properties, a moderate portfolio allocation to trend-following strategies merits consideration.

Note, however, that 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.

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