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Summary­

  • Diversification is a key ingredient to a successful trend following program.
  • While most popular trend following programs take a multi-asset approach (e.g. managed futures programs), we believe that single-asset strategies can play a meaningful role in investor portfolios.
  • We believe that long-term success requires introducing sources of diversification within single-asset portfolios. For example, in our trend equity strategies we employ a sector-based framework.
  • We believe the increased internal diversification allows not only for a higher probability of success, but also increases the degrees of freedom with which we can manage the strategy.
  • Introducing diversification, however, can also introduce tracking error, which can be a source of frustration for benchmark-sensitive investors.

Our friends over at ReSolve Asset Management recently penned a blog post titled Diversification – What Most Novice Investors Miss About Trend Following.  What the team at ReSolve succinctly shows – which we tried to demonstrate in our own piece, Diversifying the What, How, and When of Trend Following– is that diversification is a hugely important component of developing a robust trend following program.

A cornerstone argument of both pieces is that the overwhelming success of a simple trend following approach applied to U.S. equities may be misleading.  The same approach, when applied to a large cross-section of majority international equity indices, shows a large degree of dispersion.

That is not to say that the approach does not work: in fact, it is the robustness across such a large cross-section that gives us confidence that it does. Rather, we see that the relative success seen in applying the approach on U.S. equity markets may be a positive outlier.

ReSolve proposes a diversified, multi-asset trend following approach that is levered to the appropriate target volatility.  In our view, this solution is both theoretically and empirically sound.

That said, here at Newfound we do offer a number of solutions that apply trend following on a single asset class.  Indeed, the approach we are most well-known for (going back to when were founded in August 2008), has been long/flat trend following on U.S. equities.

How do we reconcile the belief that multi-asset trend following likely offers a higher risk-adjusted return, but still offer single-asset trend following strategies?  The answer emerges from our ethos of investing at the intersection of quantitative and behavioral finance.  Specifically, we acknowledge that investors tend to exhibit an aversion to non-transparent strategies that have significant tracking error to their reference benchmarks.

Trend following approaches on single asset classes like U.S. equities (an asset class that tends to dominate the risk profile of most U.S. investors) can therefore potentially offer a more sustainable risk management solution, even if it does so with a lower long-term risk-adjusted return than a multi-asset approach.

Nevertheless, we believe that how a trend following strategy is implemented is critical for long-term success.  This is especially true for approaches that target single asset classes.

Finding Diversification Within Single-Asset Strategies

Underlying Newfound’s trend equity strategies (both our Sector and Factor series) is a sector-based methodology.  The reason for employing this methodology is an effort to maximize internal strategy diversification.  Recalling our three-dimensional framework of diversification – “what” (investments), “how” (process), and “when” (timing) – our goal in using sectors is to increase diversification along the what axis.

As an example, below we plot the correlation between sector-based trend following strategies.  Specifically, we use a simple long/flat 200-day moving average cross-over system.

Correlation matrix of sector-based trend following strategies

Source: Kenneth French Data Library. Calculations by Newfound Research. Trend following strategy is a 200-day simple moving average cross-over approach where the strategy holds the underlying sector long when price is above its 200-day simple moving average and invests in the risk-free asset when price falls below.  Returns are gross of all fees, including transaction fees, taxes, and any management fees.  Returns assume the reinvestment of all distributions.  Past performance is not a guarantee of future results.

While none of the sector strategies offer negative correlation to one another (nor would we expect them to), we can see that many of the cross-correlations are substantially less than one.  In fact, the average pairwise correlation is 0.50.

Average pairwise correlation of sector trend following strategies

Source: Kenneth French Data Library. Calculations by Newfound Research. Trend following strategy is a 200-day simple moving average cross-over approach where the strategy holds the underlying sector long when price is above its 200-day simple moving average and invests in the risk-free asset when price falls below.  Not an actual strategy managed by Newfound. Hypothetical strategy created solely for this commentary and all returns are backtested and hypothetical.  Returns are gross of all fees, including transaction fees, taxes, and any management fees.  Returns assume the reinvestment of all distributions.  Past performance is not a guarantee of future results.

We would expect that we can benefit from this diversification by creating a strategy that trades the underlying sectors, which in aggregate provide us exposure to the entire U.S. equity market, rather than trading a single trend signal on the entire U.S. equity market itself.  Using a simple equal-weight approach among the seconds, we find exactly this.

The increased Sharpe ratio of a diversified trend following strategy

Source: Kenneth French Data Library. Calculations by Newfound Research. Trend following strategy is a 200-day simple moving average cross-over approach where the strategy holds the underlying sector long when price is above its 200-day simple moving average and invests in the risk-free asset when price falls below.  Not an actual strategy managed by Newfound. Hypothetical strategy created solely for this commentary and all returns are backtested and hypothetical.  Returns are gross of all fees, including transaction fees, taxes, and any management fees.  Returns assume the reinvestment of all distributions.  Past performance is not a guarantee of future results.

There are two important things to note.  First is that the simple trend following approach, when applied to broad U.S. equities, offers a Sharpe ratio higher than trend following applied to any of the underlying sectors themselves.  We can choose to believe that this is because there is something special about applying trend following at the aggregate index level, or we can assume that this is simply the result of a single realization of history and that our forward expectations for success should be lower.

We would be more likely to believe the former if we demonstrated the same effect across the globe.  For now, we believe it is prudent to assume the latter.

The most important detail of the chart, however, is that a simple equally-weighted portfolio of the underlying sector strategies not only offered a dramatic increase in the Sharpe ratio compared to the median sector strategy, but also a near 15% boost in Sharpe ratio against that offered by trend following on broad U.S. equities.

Using a sector-based approach also affords us greater flexibility in our portfolio construction.  For example, while a single-signal approach to trend following across broad U.S. equities creates an “all in” or “all out” dynamic, using sectors allows us to either incorporate other signals (e.g. cross-sectional momentum, as popularized in Gary Antonacci’s dual momentum approach) or re-distribute available capital.

For example, below we plot the annualized return versus maximum drawdown for an equal-weight sector strategy that allows for the re-use of capital.  For example, when a trend signal for a sector turns negative, instead of moving the capital to cash, the capital is equally re-allocated across the remaining sectors.  A position limit is then applied, allowing the portfolio to introduce the risk-free asset when a certain number of sectors has turned off.

The trade-off between annualized return and maximum drawdown when capital re-use is allowed

Source: Kenneth French Data Library. Calculations by Newfound Research. Not an actual strategy managed by Newfound.  Hypothetical strategy created solely for this commentary and all returns are backtested and hypothetical.  Returns are gross of all fees, including transaction fees, taxes, and any management fees.  Returns assume the reinvestment of all distributions.  Past performance is not a guarantee of future results.

The annotations on each point in the plot reflect the maximum position size, which can also be interpreted as inversely proportional the number of sectors that have to still be exhibiting a positive trend to remain fully invested.  For example, the point labeled 9.1% does not allow for any re-use of capital, as it requires all 11 sectors to be positive. On the other hand, the point labeled 50% requires just two sectors to exhibit positive trends to remain fully invested.

We can see that the degree to which capital is re-used becomes an axis along which we can trade-off our pursuit of return versus our desire to protect on the downside. Limited re-use decreases both drawdown and annualized return.  We can also see, however, that after a certain amount of capital re-use, the marginal increase in annualized return decreases dramatically while maximum drawdown continues to increase.

Of course, the added internal diversification and the ability to re-use available capital do not come free.  The equal-weight sector framework employed introduces potentially significant tracking error to broad U.S. equities, even without introducing the dynamics of trend following.

Tracking error between U.S. equities and an equal-weight sector portfolio

Source: Kenneth French Data Library. Calculations by Newfound Research. Not an actual strategy managed by Newfound.  Hypothetical strategy created solely for this commentary and all returns are backtested and hypothetical.  Returns are gross of all fees, including transaction fees, taxes, and any management fees.  Returns assume the reinvestment of all distributions.  Past performance is not a guarantee of future results.

We can see that the average long-term tracking error is not insignificant, and at times can be quite extreme.  The dot-com bubble, in particular, stands out as the equal-weight framework would have a significant underweight towards technology.  During the dot-com boom, this would likely represent a significant source of frustration for investors.  Even in less extreme times, annual deviations of plus-or-minus 4% from broad U.S. equities would not be uncommon.

Conclusion

For investors pursuing trend following strategies, diversification is a key ingredient.  Many of the most popular trend following programs – for example, managed futures – take a multi-asset approach.  However, we believe that a single-asset approach can still play a meaningful role for investors who seek to manage specific asset risk or who are looking for a potentially more transparent solution.

Nevertheless, diversification remains a critical consideration for single-asset solutions as well.  In our trend equity strategies here at Newfound, we employ a sector-based framework so as to increase the number of signals that dictate our overall equity exposure.

An ancillary benefit of this process is that the sectors provide us another axis with which to manage our portfolio.  We not only have the means by which to introduce other signals into our allocation process (e.g. overweighting sectors exhibiting favorable value or momentum tilts), but we can also decide how much capital we wish to re-invest when trend signals turn negative.

Unfortunately, these benefits do not come free.  A sector-based framework can also potentially introduce a significant degree of tracking error to standard equity benchmarks.  While we believe that the pros outweigh the cons over the long run, investors should be aware that such an approach can lead to significant relative deviations in performance over the short run.

Corey is co-founder and Chief Investment Officer of Newfound Research. Corey holds a Master of Science in Computational Finance from Carnegie Mellon University and a Bachelor of Science in Computer Science, cum laude, from Cornell University. You can connect with Corey on LinkedIn or Twitter.