Swedroe: Why Trend-Following Works

November 17, 2017


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.


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