For many investors, trend following can be difficult because, as Seager put it, “you get prolonged periods of not much happening. But then you get the occasional spike upward.”
Here’s how trend following can work. Consider the fact that a random walk of markets is by definition unpredictable – the long-term P&L of any strategy applied to it has to be flat. But it can fluctuate upward for several consecutive periods or downward for several consecutive periods, in a statistically insignificant manner. The trend follower can still come out ahead over short, statistically insignificant periods, hence the convexity or protection against big moves.
“Even a random price can sometimes drift strongly up or down and when that persists then the trend follower makes money — more and more if a crisis persists,” Seager said. CFM has investigated this statistical phenomenon in a mathematical research paper.1
“We’ve done a lot of work on trend convexity, which is a mechanical effect,” he said. “If one applies a trend-following approach to a random walk price time series then there is protection against big moves up and down.”
The coronavirus-driven market sell-off brings any strategy’s protective features into sharp focus. “At CFM, we’ve relied upon trend following historically as a performance driver, and we, and many others, have realized that improving risk-adjusted returns comes at the expense of reducing convexity. Based on discussions with clients, we have found, however, that there is a demand for convexity and protection. We therefore now have two products ― one trying to get the highest risk-adjusted returns and another strategy that is trying to get the most out of trend following in terms of convexity that then delivers slightly less in terms of Sharpe ratio,” Seager said.
Over the long term, investors using trend following as a return enhancer should expect a net Sharpe ratio of about 0.5. Research by CFM has found that gross returns from a six-month trend follower have never been negative in any historical 10-year period, unlike equities.2
In addition to equities, trend following has shown to deliver statistically significant excess returns in asset classes ranging from commodities to currencies to stock indexes to bonds, over very long-time series.
For equity investors, say a pension plan that is a long-term investor seeking to maximize risk-adjusted returns, rather than allocating 100% of the risk budget ― or, more narrowly, the equity budget ― to stocks, 20% could be allocated to trend following and the rest to equities.
“What you’re essentially doing is getting the same level of risk-adjusted returns with less volatility and, therefore, less draw down,” Seager explained. “That’s really what you’re achieving. And I think that is something most people would be very happy about.
“Throughout the cycle, the smart investor is diversified in risk-on and defensive strategies — a mix of equities with a diversifying and defensive allocation to trend following should give better outcomes,” he said. “It is never too late to adopt trend following.”
1“Making Fat Right Tales Fatter with Trend Following….most of the time.” CFM. November, 2018. https://www.cfm.fr/assets/Uploads/PDFs/2018-Making-fat-right-tails-fatter-with-trend-following-most-of-the-time.pdf
2 Y. Lempérière, C. Deremble, P. Seager, M. Potters, J. P. Bouchaud. “Two centuries of trend following,” Capital Fund Management, Paris, France. April 15, 2014. https://www.cfm.fr/assets/ResearchPapers/2014-Two-centuries-of-trend-following.pdf
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