How do trend following strategies deliver alpha and, how these strategies can do this in volatile markets?

Trend following strategies can capture upward and downward trends in hundreds of markets, which has made such strategies popular alternative investments to diversify risk in client portfolios. This article from GSFM – which distributes the trend following Man AHL Alpha (AUD) strategy – examines trend following strategies in the current market environment.

A trend following strategy is an investment approach that aims to identify and exploit trends in financial markets. The approach is premised on the belief that prices tend to move in persistent trends and that by following these trends, one can profit from the direction of the market.

The core idea underpinning a trend following strategy is to buy or sell an asset based on its recent price behaviour. If an asset’s price has been rising, the strategy will buy or go long, expecting the trend to continue. Conversely, if the price has been falling, the strategy will sell or go short, anticipating further declines. Trend following trading is reactive by nature; it doesn’t seek to forecast markets or prices.

Trend following strategies typically use technical analysis tools and indicators to identify trends and generate trading signals. The investment approach employed is generally a systematic, quantitative process that exploits a range of technical or price driven signals through investment in a broad range of futures and forward markets, as well as highly liquid over the counter (OTC) options markets.

Strategies identify and capture trends across a range of sectors: stocks, bonds, currencies, agricultural investments, commodities, interest rates, energy and utilities, and credit. Trend following strategies may invest across hundreds of markets and sectors at any one time.

It’s important to note that trend following strategies do not attempt to predict market tops or bottoms. Instead, they aim to capture the middle portion of a trend and profit from sustained price movements. However, like any trading strategy, trend following is not foolproof and carries risks, including the possibility of false signals and whipsaw movements in volatile markets.

Trend following and equity markets

Trend following strategies perform as well as equities in the long term – and get there with lower risk, smaller drawdowns and do best when equities are at their worst. Further, trend following strategies tend to do best when there are big macroeconomic shocks. Financial markets typically need time to digest all the information associated with macroeconomic shocks and in most cases, there’s a big equity sell off as well.

A good example is that of the Global Financial Crisis; it started as a situation that seemed contained in 2007 but ultimately, things rapidly moved from bad to worse. The contagion quickly moved from one asset type to all asset classes. It’s in such circumstances that trend followers can take advantage of trends and make profits.

Since inception in 1986, the Barclay BTOP50 Index (which comprises of mostly trend-following strategies) has returned 7.0% annualised, only 0.7% shy of world stocks (figure one). Trend-following’s risk is significantly lower, however, whether risk is measured in terms of volatility (9.6% versus 14.4%) or maximum drawdown (-16% versus -50%).

Finance 101 says that trends should not exist; markets are efficient, and information is instantaneously reflected in prices. Of course, this ignores the fact that decisions lag news flow, that economic cycles play out over years and that humans get emotional; we hate losses more than we love gains, and in doing can often make irrational choices^[1].

At face value, trend following is a remarkably simple strategy. Buy something that is going up and sell something that is going down. Try and generate a return from trend-following in one market, however, and the results might not satisfy. There’s generally only a slight edge, which is why managers run the strategy over tens, if not hundreds, of liquid markets to eke out consistent returns. They use computers for repeatability and because computers don’t get emotional.

Trend following and inflation

A trend follower typically buys winners and sell losers; winners being securities that have been going up in price, the losers securities those which have been going down in price. More often than not, markets tend to continue in the same direction when there has been a big macroeconomic shift; markets need time to digest information and then gradual pricing in of information leads to trending behaviour.

Inflation is a good illustration of this. Inflation first surprised markets in 2022 – and markets kept being surprised about the upward spiral in the inflation data. Accordingly, trend followers strategically positioned themselves to benefit from the continued deterioration in markets. Similarly, so far in 2023, inflation has continued to surprise on the upside in many markets. Inflation has had a significant impact on security prices; for example, bond markets have sold off for an extended period of time and trend followers could have profited from that by being short bonds.

Trend following is generally a successful strategy during inflationary periods because inflation causes actual price movements in financial markets. Aside from the traditional bond and equity markets, there’s price inflation on commodities and which, in turn, has an effect on the currencies of commodity producing countries. So, for strategies following trends across a broad range of securities, rising (and falling) inflation creates trends that trend following managers can exploit.

Similarly, trend following tends to do well in disinflationary environments, when the trends are the reverse of what we are seeing today.

Genuinely diversifying

Since its inception, the correlation of the BTOP50 to world stocks and other traditional markets is effectively zero (figure two). Intuitively, this is because trend-followers seek to capture trends in all these markets simultaneously, either up or down. Correlations produced by Man Group illustrate how little diversification is obtainable within asset classes. World stocks correlate to US stocks at 0.97, world bonds to US bonds at 0.86. The real surprise is that world stocks correlate to a diversified ‘60/40’ portfolio at 0.99.

Crisis alpha

Long-term low correlation is one thing, but trend-following strategies have another trick up their sleeve: negative correlation to risk assets in times of crisis. Coined ‘Crisis Alpha^[2] it relates to trend following’s historic positive performance during sustained equity market weakness.

As figure three illustrates, the BTOP50 returned 37 percent when the tech bubble burst and 17 percent during the Global Financial Crisis. Both of these episodes lasted years. During shorter periods such as the Covid-19 episode, however, performance is more mixed. This is because trend-following strategies take time – typically 3-6 months – to discover, and trade into, a new trend.

Why aren’t trend following strategies more popular?

The performance of a traditional equity portfolio is fairly simple to understand, particularly if it is well-diversified. It hopefully goes up in the long term, but if there is a negative headline, a global pandemic for example, advisers and investors might anticipate some losses. As shown in figure two, diversification across regions, or even a 40 percent allocation to bonds, doesn’t help too much here.

Performance of a trend-following strategy is far less intuitive. Trend-following strategies trade many markets across multiple asset classes, not just equities. Indeed, a positive beta to equities, or risk assets in general, could originate from places other than equities – long emerging markets FX or short gold, for example. Complicating things further, this positioning can change as trends in different places emerge or dissipate. A trend-follower’s beta to any asset is dynamic.

How can an investor get comfortable with the performance of a trend-following strategy? The key lies in knowledge of positioning.

Potential investors should understand what trend sensitivity is in their investment. ‘Medium-term’ trend following space spans managers with trend sensitivity between two and six months, in Man Group’s view. At the shorter end of that spectrum, a manager may be able to shift position quickly, being more responsive in a crisis.

At six months trend sensitivity, on the other hand, the manager may respond more slowly to a change in market direction but should have improved longer-term performance. Market choice can also be a factor in understanding performance.

Trend-following strategies are often portrayed as ‘black box’, inferring opaqueness or mystery, which could originate in lack of knowledge of positioning, or because of the use of computers. But trend-following strategies use rules which can be written down, are based on understandable inefficiencies in markets, and computers are utilised for scalability and to remove human emotion. More a ‘transparent’ box than a black box.

A reason frequently cited for not liking trend-following is that performance was flat for an extended period post 2008. Indeed, as figure one illustrates, the BTOP50 index returned zero between 2009 and 2019 when equities returned around 200%^[3]. This may be true, but how bad is ‘flat’ in comparison to the 50% or so lost by equities twice since 2000?

However, if you hold a trend following strategy alongside your traditional equity portfolio, in the long term, history suggests that both should be profitable. Further, during crises, trend-following can potentially help cushion losses. Holding the two together gives higher risk-adjusted returns and lower drawdowns than traditional assets alone.

As highlighted in figure four, over the last four decades or so, substituting up to 50 percent trend following to a traditional portfolio preserves return, and also substantially reduces volatility and drawdowns. For example, notice how a 50/50 blend eradicates 2022’s drawdown.

Trend following strategies have gained popularity as alternative investments for diversifying risk in client portfolios due to their ability to capture upward and downward trends in various markets. Over the long term, trend following strategies have performed as well as equities but with lower risk and smaller drawdowns. They have shown their best performance during periods of significant macroeconomic shocks and equity market weakness, such as the Global Financial Crisis.

To finish where we started, trend-following performs as well as equities in the long term, is lowly correlated, has better risk-management properties, and generally works well when equities don’t. Trend following strategies also work particularly well in conjunction with equity portfolios. What’s not to like about that?

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Notes:
[1] Kahneman, D., & Tversky, A. (1979). “Prospect theory: An analysis of decision under risk”. Econometrica, 47, 263-291.
[2] Greyserman, A., & Kaminski, K. M. (2014). “Trend Following with Managed Futures. The Search for Crisis Alpha”. Wiley
[3] From 31 January 2009 to 31 May 2019, MSCI World Net Total Return Index, Hedged USD

Important information: The information included in this article is provided for informational purposes only. The information contained in this article reflects, as of the date of publication, the current opinion of Man Group plc and is subject to change without notice. Sources for the material contained in this article are deemed reliable but cannot be guaranteed. We do not represent that this information is accurate and complete, and it should not be relied upon as such. Any opinions expressed in this material reflect our judgment at this date, are subject to change and should not be relied upon as the basis of your investment decisions. All reasonable care has been taken in producing the information set out in this article however subsequent changes in circumstances may occur at any time and may impact on the accuracy of the information. Neither Man Group plc, GSFM Pty Ltd, their related bodies nor associates gives any warranty nor makes any representation nor accepts responsibility for the accuracy or completeness of the information contained in this article.

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