08 Aug Trend Following — 140 Years of Data Supports its Value
AQR updates it paper on Trend Following performance over the last century. Despite the strategy experiencing poor recent performance, it brings tremendous value to stock and bond portfolios over time by 1) increasing returns and 2) lowering volatility and max loss. A win-win-win in my book.
Trend Following ain’t perfect. No investment strategy is, but the data proves Trend Following’s long-term value. There’s no arguing it. Returns may not be as consistent as we’d like them to be, but every strategy has its own problem(s). Markets and strategy performance are irregular, so we must be careful not to dismiss the value of Trend Following or any other strategy, whenever it experiences a rough patch.
Do not allow recent performance to distort the long-term benefits.
- Trend Followings posts positive returns in every decade since 1880.
- Since 1880, little correlation exists between Trend Following versus stocks (-1%) and bonds (-3%). The highest correlation to stocks occurs in the 1940’s (33%); to bonds, in the 2010’s (28%). The lowest correlation to stocks equals -34% in the 2000’s and to bonds at -37% in the 1960’s. (Note: high correlation readings are typically 66% and above; low correlation is -66% and below.)
The main selling points of investing in Trend Following persist over time — decade after decade.
One) Trend Following typically performs well when stocks produce large trends, up or down. The illustration below shows a smile, which indicates higher performance during major bull and bear markets.
Two) An allocation to Trend Following comes in handy during times of market stress. In the 10 worst periods for the 60/40 portfolio, Trend Following shines. It displays an consistent ability to limit losses and even produce a profit during major bear markets and panics.
Three) Trend Following increases returns while lowering volatility and the max loss of the 60/40 portfolio. If you intend to improve your absolute returns and your gains relative to the pain you take (Sharpe Ratio), then making an allocation to Trend Following might be a wise decision.
Why Has Recent Performance Been Poor?
From late 2008 to mid 2014, the average correlation across many markets increases substantially. This stems from the “risk-on, risk-off” mentality that makes many traditionally non-correlated markets to move together either up or down. During an environment like this, trend traders lose diversification and take many small losses (that add up to a larger loss) due to the large number of whipsaws.
This period of high correlation coincides with the end of the Financial Crisis, bailouts and the beginning of a worldwide medication towards equity losses (Quantitative Easing). We are now far removed from the Crisis and central banks have begun raising interest rates. This might signal a return to a normal market environment out of a central bank controlled one.
I believe we’ve gone through a very unique time in markets that we probably won’t see again for a very long time. I believe Trend Following has weathered a perfect storm of high correlation and sideways markets very well. It’s very hard to break a strategy that obeys the laws of nature — follow the trend, ride winners, cut losses and manage risk.
Full AQR paper: https://papers.ssrn.com/sol3/papers.cfm?abstract_id=2993026
Article written by Michael Melissinos. Michael Melissinos is the Founder and CEO of Melissinos Trading, a Managed Futures asset manager specializing in identifying and capturing price trends in global commodity and financial markets. He also maintains a blog at michaelmelissinos.com where he writes about various investing topics.
Past Performance is Not Necessarily Indicative of Future Results
There is always a risk of loss in futures trading.
This communication is for information purposes only and should not be regarded as an offer to sell or as a solicitation of an offer to buy any financial product, an official confirmation of any transaction, or as an official statement of Melissinos Trading LLC. All information is subject to change without notice.
These charts show examples of trends. Inclusion of a chart as a trend example does not imply any kind of recommendation to buy, sell, hold or stay out.