CPD: How much trend following should investors hold in a portfolio?

How can trend-following strategies sit within a more traditional long only multi asset portfolio?

Trend following strategies have a number of properties that are desirable to investors. In this article from GSFM’s investment partner Man Group, these properties are examined, and the big question answered – how much trend following should investors hold in a portfolio?

Trend following has a number of desirable properties: comparable long-term returns to equities, zero long-term correlation to traditional assets and historically observed strong performance in crisis periods (aka crisis alpha). Many advisers recommend trend following strategies to their clients for these exact reasons. The natural follow up question – one which the team at Man Group has been increasingly fielding – is ‘how much trend following should investors hold in a diversified portfolio?’

The textbook answer, in the absence of any constraints, would be the proportion that generates the optimal risk-adjusted reward, or Sharpe ratio. However, there are often some real-world constraints – investor preferences, lookback window and tracking error – that come into play and may shrink a trend following allocation. Each of these are investigated in this article.

What is trend following?

Firstly, a recap about trend following. A trend following strategy aims to capitalise on trends within financial markets, operating under the belief that prices tend to move persistently in certain directions. Rather than attempting to forecast markets, this approach reacts to recent price behaviour. When an asset’s price has been rising, the strategy buys or goes long, anticipating the trend to continue; conversely, if prices have been falling, it sells or goes short, expecting further declines.

Utilising technical analysis tools and indicators, trend following strategies identify trends and generate trading signals. Typically systematic and quantitative, these strategies exploit various technical signals across a broad spectrum of futures, forward markets and highly liquid over the counter (OTC) options markets. They span multiple sectors, including stocks, bonds, currencies, agricultural commodities, interest rates, energy, utilities and credit, often investing across hundreds of markets simultaneously.

Importantly, trend following strategies do not attempt to pinpoint the peak or trough of any one market. Instead, the strategy seeks to capture the middle portion of a trend and profit from sustained price movements. However, like any trading strategy, trend following carries risks, including false signals and whipsaw movements during volatile markets.

Trend following and long only multi asset portfolios

A large proportion of investor portfolios typically comprise a long only multi asset (LOMA) allocation. The most common example is the 60/40 portfolio: 60 percent global equities and 40 percent global bonds, notionally allocated. While Australian investors tend to have an overweight to Australian equities, for the scope of this article the focus is on a global allocation to equities and bonds.

For most of the 21st century, 60/40 has been the hallmark of multi asset investing, driven by the twin tailwinds of rising bond and equity prices, while being negatively correlated with each other. However, as illustrated in figure one, the correlation between bonds and equities has recently trickled into positive territory, a reversion to what was seemingly the status quo for most periods before the turn of the century.

Thus, it may be that traditional portfolios, such as 60/40, need additional sources of diversification more than they have done in this century.

Figure two is an analysis of the optimal combination, as defined by Sharpe ratio, of trend following
(proxied by the BTOP50 Index) and 60/40 (proxied by 60% MSCI World USD Hedged Index and 40% Bloomberg Global Aggregate USD Hedged Index) through time.

The different points on the x-axis of the chart refer to the different lookback windows used when ascertaining the optimal combination but all running through to December 2023.

For example, the point in January 1995 computes the optimal combination using a start date of January 1995 up to December 2023, whereas a point in January 2015 determines the optimal combination using data from that point up until December 2023.

The swings of the optimal percentage of trend following (dark blue) curve in figure two illustrate its strongly time-varying nature. With that said, these oscillations are relatively intuitive. Trend following has a relatively higher optimal weight in the early period of the sample given its outperformance, and on a relatively lower level of volatility, throughout the dot-com bubble burst and the Global Financial Crisis (GFC), periods where traditional assets struggled.

However, following the GFC, trend following entered what many regard as the ‘CTA winter’, where returns were broadly flat, which leads to a drop in optimal weight. From 2022 onwards, the ratio oscillates wildly given stark performance differences between trend following (+14.9%) and 60/40 (-13.5%) during 2022’s inflationary burst.

To most credibly determine the optimal combination, and to overcome the outsized effect of ‘noise’, statistics suggest that we should refer to the longest sample available. Looking at the full sample, this indicates an optimal 40 percent allocation to trend following and 60 percent to 60/40.

However, ‘optimal’ is in the eye of the beholder and some investors, such as those who are expressly interested in trend following’s defensiveness, may consider drawdown to be the most pertinent measure of optimal.

Figure three plots the percentage of trend following – when combined with 60/40 – that yields the smallest maximum drawdown. Trend following’s positive return skew means that its drawdowns are relatively muted through time, leading it to have a relatively higher weight when optimising for the lowest maximum drawdown.

Looking at the full sample from January 1995 to December 2023 indicates the optimal percentage of trend following to yield the lowest maximum drawdown when combined with 60/40 is 63 percent.

Tracking in the right (or wrong) direction?

Admittedly, an investor or allocator looking at the aforementioned optimal figures may be surprised at the sizes of the proposed trend following allocations…and there is some justification for that reaction.

While trend following is an active, absolute return strategy and therefore not managed to a benchmark, 60/40 or equities are the industry gold standard for performance evaluation. There is some merit to this.

Equities, and by association, 60/40, have been one of the best performing asset classes of the last 20 years. Therefore, the risk of underperforming equities or a 60/40 for a sustained period invites challenging questions from clients and is therefore a real-world constraint to consider when designing asset allocations.

However, trend following’s convexity means that its tracking error to compared to 60/40 is generally at its greatest when we need it most – or, in other words, when 60/40 is at its worst. Figure four illustrates the rolling 12-month tracking error of a 100 percent trend following portfolio and the Sharpe-optimal combination (40 percent Trend and 60 percent 60/40) to 60/40. The spikes in the tracking error curves are contemporaneous to drawdowns for 60/40, while the curves taper towards their lows when 60/40 rallies.

If it moves, monetise it!

The point of this article is not to say advisers should significantly down weight the LOMA component of their clients’ portfolio and replace it with trend following. Equities and bonds have accrued significant historical gains, and justifiably make up a meaningful portion of strategic asset allocations. However, the cash efficiency of instruments traded by trend following strategies means that little additional cash is needed to fund an allocation.

Let us take the following example. Allocating 90 percent of cash to the LOMA and 10 percent to trend following, with the latter levered up by four times, leads to roughly 40 percent trend following, 90 percent LOMA, or 30 percent trend following and 70 percent LOMA in normalised notional allocation terms. See Solution one in figure five.

But this is just one of many implementation options. Another approach, that preserves 100% of the LOMA, would be to replicate the LOMA using a swap or futures, with the cash-efficiency creating excess cash to allocate to the trend following component – solution two in figure five. Both options also facilitate customisation in terms of the amount of leverage desired.

Account curves and drawdown profiles of these three potential solutions are illustrated in figure six. Note how solution two, with the same amount of 60/40 as our original 60/40 portfolio, enhances the return of 60/40 by 2.3% per annum on similar volatility and drawdown.

History shows what to expect from trend following when rates are being cut

As a side note and having reached an inflection point in the rates cycle, advisers may wonder what to expect from trend following strategies when rates are cut.

Towards the end of 2023, the ‘higher-for-longer’ narrative evaporated as inflation moderated. The Federal Reserve’s dovish pivot in December 2023 signalled not only the end of one of the most aggressive rate hiking cycles in modern history, but also that rate cuts were firmly on the roster for 2024, with the Fed dot-plot pricing in 75bp of cuts over the course of the year.

We do not have to go back far to see how trend following performs during rate hiking cycles. Trend following’s 2022 blockbuster performance was a prominent example, with the Barclay BTOP50 Index (BTOP50) returning 15%. But as we now stand at an important inflection point, how does trend following perform during rate cutting cycles?

To help answer this is a comparison of the performance of the BTOP50 since its inception in 1987 against the Federal Funds Target Rate (FFTR), denoted by the grey shaded area in figure seven. The performance of the BTOP50 is then plotted relative to two distinct environments: firstly, when the FFTR is rising (yellow line in figure seven) and secondly, when the FFTR is being cut (light blue line in figure seven).

Whether a period is classified as a hiking cycle or a cutting cycle is determined by the 12-month forward level of the FFTR. If this is greater or equal to 75bp, it is classified as the former and if it is less than or equal to -75bp, it is classified as the latter.

The rationale for choosing this classification is twofold; firstly, it aligns with the Fed’s latest dot-plot, which forecasts 75bp worth of cuts over 2024, and secondly, it accounts for the fact that interest rates lag inflation, so goes some way towards capturing the forward-looking nature of monetary policy, as well as the movements in asset prices that are driven by a change in expectations.

For completeness, the returns corresponding to the periods where the FFTR is largely static (dark blue line in figure seven) is also plotted. Performance is then held constant when the environment switches.

The first observation to be made from figure seven is that trend following performance is positive during the majority of hiking cycles classified over the period, with an annualised return for the BTOP50 of 8%. 2022 helps validate this observation as trend following profited from sizeable trends in fixed income markets and the US dollar, which were precipitated by the Fed’s unprecedented hiking cycle, to the tune of 425bp.

The second, and more pertinent observation given the current environment, is that trend following performance has been positive during each cutting cycle since the 1980s, with the BTOP50 annualising 9%. Indeed, it can be observed that the relationship is more pronounced during cutting cycles than over hiking cycles.

Finally, over periods where rates are relatively static, we find that the annualised performance of the BTOP50 is 5%, underperforming the BTOP50 during both cutting and hiking cycles.

This analysis provides a historical view of trend following performance, which could apply to future rate cutting cycles. It is analogous to the analysis undertaken by Neville^[1] which examines around a century of data to show that trend following is not only a robust performer during inflationary periods in general, but also in the six-and 12-month timeframes following inflation’s peak.

While real-world constraints often predicate that trend following may not get the allocations the two measures assessment covered in this article suggest, advisers should give trend following serious consideration for inclusion in portfolios in more meaningful quantities than it historically has been. Aside from its desirable crisis alpha and risk-management properties, it generates attractive long-term risk-adjusted returns while being diversified to traditional assets. Cash efficiency also means that it need not precipitate abandoning a traditional LOMA approach to accommodate more trend following, but instead combined in a robust framework that uses leverage to monetise the diversification.

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Notes:
[1] Neville, H., “The Road Ahead: Inflation Can Go Down as Well as Up”, May 2022

Important information: The information included in this article is provided for informational purposes only and is general advice only. It does not take into account an investor’s own objectives. 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.