Based on Hesperian Wealth’s research, trend following (also called managed futures) is one of the few exceptions where an “alternative investment” lives up to the hype. Most others are too correlated to stocks and bonds to add any real diversification. And it’s never been easier or cheaper to incorporate what we call “the third asset class” into a diversified, liquid investment portfolio.
What is Trend Following?
Trend following involves betting on rising markets continuing to rise and betting on falling markets continuing to fall. Well-established fund managers may be using sophisticated technical systems to identify trends, but at the end of the day, they are simply exploiting the fact that financial markets have exhibited trends and moved in cycles throughout recorded history. The strategy is supported by substantial academic research and a multi-decade-long live track record of funds employing it (not to mention centuries of simulated performance in some studies).
Trend following provides investors with additional sources of return they couldn’t otherwise benefit from. For one thing, these strategies can bet on prices falling, whereas the typical buy-and-hold investor is wholly dependent on prices going up. They can invest in currency, commodity, and interest rate markets that investors rarely have exposure to. They are also dynamic: Their positioning can change depending on the location and strength of trends across global markets. What’s more, trend-following strategies typically execute a systematic rules-based investment process, akin to Hesperian’s own, so performance is not dependent on any investment guru’s personal “thesis” or susceptible to the frailties of human emotional decision making.
Why Invest in Trend Following?
1. A diversified source of return
Over the long term, trend-following strategies have delivered investors returns, volatility, and maximum drawdowns somewhere in between that of stocks and bonds. At the same time, they have had little to negative correlation with stocks and bonds, the traditional components of most investment portfolios. So historically, adding them in as the third element of a portfolio would have added to return while actually lowering volatility.
2. Returns and diversification when your portfolio needs it most
More than just general diversification, trend-following strategies have tended to provide positive returns when your portfolio most needs them. Trend-following strategies have historically performed well (and usually much better than bonds) during sustained bear markets in stocks or other crises. They generated a positive return in each of the last seven largest stock market drawdowns. This preserves capital investors and their financial advisors can use to buy more traditional investments once they go on sale.
3. A rare dual deflationary and inflationary hedge with a low opportunity cost
Unlike more conventional diversifiers such as commodities or bonds, trend-following strategies have naturally tended to deliver the highest returns during both deflationary and inflationary periods, while still performing decently on average during “normal” times too—a rare combination of characteristics that would be extremely valuable to us investors were it to persist.
Why Does Trend Following Work?
Several human biases and structural market characteristics exist that are likely responsible for trend following’s profitability:
- Anchoring: Investors tend to underreact at first to new data that conflicts with long-standing conditions, slowing trends down enough for trend followers to establish positions.
- The Disposition Effect: Investors then commonly hold on to losing positions after trends reverse not wanting to psychologically “realize” a loss, slowing prices down further. At the same time, as trends are in progress, many investors sell their winning positions too early to “lock in” gains they’re afraid of losing, leaving money on the table for trend-following systems.
- Non-Profit-Seeking Participants: Passive investors who robotically rebalance unwittingly trade against trends. And governmental or monetary authorities sometimes intervene in markets, either slowing price discovery or further propelling an existing trend.
- Market Frictions: While markets are amazingly clairvoyant at times, capital is often still unable to move fast enough to incorporate all information into prices immediately allowing trend followers time to position their portfolios.
- The Recency Bias: Investors have been shown to systematically assume recent performance is representative of future returns and bet accordingly, which also supports existing trends.
- Herding & Performance Chasing: Once a trend is collectively recognized—usually only once it’s overwhelmingly obvious—undisciplined investors and fund managers commonly jump on the bandwagon and bet on what’s been working, prolonging trends further, sometimes beyond any conceivably rational justification.
All this works to consistently give trend-following systems time to position to profit from trends and/or make investing systematically in trends more profitable than it otherwise would be. We have seen no convincing evidence that human nature has changed such that these biases have dissipated. Nor have markets evolved to the degree that they are efficient enough to materially lower the expected return of trend-following strategies. Finally, in relative terms, the capital employed in trend-following strategies is small and nowhere near the level at which its profitability would be traded away.
Does Trend Following Work All the Time?
No. As with any investment strategy, trend following will go through periods of underperformance relative to other asset classes. When a long-term trend reverses (as all trends do eventually), trend strategies will incur losses on related positions until their systems adjust. And while uncommon, there have been periods when markets have been relatively trendless for a while. During these times, trend-following strategies can be whipsawed back and forth and bear many small trading losses hurting performance.
But this is not an argument for not investing in them. No investment appreciates in a straight line. Stock markets have suffered severe declines repeatedly every three to 10 years, some far exceeding anything trend-following strategies have ever experienced. Yet stocks make up the largest allocation in most investors’ portfolios! Over the long term, trends have persisted and trend-following strategies have performed well in an uncorrelated fashion.
How Hesperian Accesses the Trend-Following Asset Class For Its Clients
Historically, the three issues facing investors wanting exposure to trend following were access, fees, and single-manager risk (the chance that the particular trend-following strategy you pick ends up performing much lower than the hypothetical index you evaluated in your research). Today, Hesperian incorporates innovative trend-following funds into its portfolios that solve for all these issues.
We use funds structured as more-investor-friendly Exchange-Traded Funds with daily liquidity, no investment minimums, no investor restrictions, and much lower expenses. And the funds we recommend also attempt to statistically replicate the index of trend-following funds, substantially reducing manager risk. This is as close to low-cost indexing as you can get for the trend-following asset class. While index replication loses something, we think these new funds may even end up outperforming the trend-following indexes just because they save investors so much on fees.
This goes to show how working with a professional wealth manager with deep investment knowledge can help you not just identify diversifying strategies you may not have been aware of, but also select the optimal way to gain exposure to them in your portfolio.
All content presented in this article is for informational purposes only. Materials presented should not be interpreted as a solicitation or offer to buy or sell a security or the rendering of personalized investment advice, which can only be provided through one-on-one communication with a financial advisor. The content reflects the opinions of Hesperian Wealth LLC (HW), except where cited, which are subject to change at any time without notice. The information contained herein has been obtained from sources believed to be reliable, but the accuracy of the information cannot be guaranteed. All information or ideas provided should be discussed in detail with a financial, tax, or legal advisor prior to implementation.
Investing involves substantial risk, including the potential loss of principal. HW makes no guarantee of financial performance nor any promise of any results that may be obtained from relying on the information presented. HW may analyze past performance, but past performance may not be indicative of future performance.
This article includes mention of some of the primary methods of investment analysis that HW employs: Technical Analysis, Cyclical Analysis, and Charting Analysis.
Technical analysis involves using chart patterns, momentum, volume, and relative strength in an effort to pick sectors that may outperform market indices. However, there is no assurance of accurate forecasts or that trends will develop in the markets we follow. In the past, there have been periods without discernible trends and similar periods will presumably occur in the future. Even where major trends develop, outside factors like government intervention could potentially shorten them.
Furthermore, one limitation of technical analysis is that it requires price movement data, which can translate into price trends sufficient to dictate a market entry or exit decision. In a trendless or erratic market, a technical method may fail to identify trends requiring action. In addition, technical methods may overreact to minor price movements, establishing positions contrary to overall price trends, which may result in losses. Finally, a technical trading method may underperform other trading methods when fundamental factors dominate price moves within a given market.
Cyclical analysis is a type of technical analysis that involves evaluating leading indicators, recurring price patterns, and trends based upon business cycles. Economic/business cycles may not be predictable and may have many fluctuations between long-term expansions and contractions. The lengths of economic cycles may be difficult to predict with accuracy and therefore the risk of cyclical analysis is the difficulty in predicting economic trends and consequently the changing value of securities that would be affected by these changing trends. There are additional inherent limitations to relying on the indicators mentioned: Variables that were predictive of market events or economic conditions in the past may not be predictive in the future. The data used may not have been available to investors in the periods shown or may have been revised later.
Performance is shown for illustration purposes only and does not reflect the actual returns of any client accounts of HW. Any performance presented is hypothetical and may be based on noninvestible indexes, which do not reflect the total fees and expenses that would have been paid by an HW client account, which include Hesperian’s investment management fee in addition to the operating expenses and fees of any underlying funds and other investments. It is not possible to invest in an unmanaged index.
This article reflects the opinions of HW, which are subject to change at any time without notice. Third-party information provided is obtained from sources that HW believes to be reliable. However, HW has not independently verified or analyzed all such information and so cannot guarantee its accuracy or completeness.
This article is in part based on the following independent academic and professional sources:
“A Century of Evidence on Trend Following Investing”, Brian Hurst, Yao Hua Ooi, Lasse Heje Pedersen, AQR Capital Management
“Time-Series Momentum”, Brian Hurst, Yao Hua Ooi, Lasse Heje Pedersen, AQR Capital Management
“Demystifying Managed Futures”, Brian Hurst, Yao Hua Ooi, Lasse Heje Pedersen, AQR Capital Management
“Regime-Based Investing”, AHL Man Group
“The Best Strategies for Inflationary Times”, Henry Neville, Teun Draaisma, Ben Funnell, Campbell Harvey, and Otto van Hemert, AHL Man Group
“The Rise of the Managed Futures ETF”, Kathryn Kaminsky, Scott Sample, AlphaSimplex Group
“Trend Following with Managed Futures: The Search for Crisis Alpha”, Kathryn Kaminsky, AlphaSimplex Group, Alex Greyserman, ISAM