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Summary­

• Trend-following strategies exploit the fact that investors exhibit behavioral biases that cause trends to persist.
• While many investment strategies have a concave payoff profile that reaps small rewards at the risk of large losses, trend-following strategies exhibit a convex payoff profile, one that pays small premiums with the potential of a large reward.
• By implementing a trend-following strategy on equities, investors can tap into both the long-term return premium from holding equities and the convex payoff profile associated with trend following.
• There are multiple ways to include a trend-following equity strategy in a portfolio, and the method of incorporation will affect the overall risk and return expectations in different market environments.
• As long as careful consideration is given to whipsaw, hedging ability, and implementation costs, trend-following equity can be a potentially useful diversifier in most traditionally allocated portfolios.

A Balance of Risks

Most investors – individual and institutional alike – live in the balance of two risks: failing slow and failing fast.  Most investors are familiar with the latter: the risk of large and sudden drawdowns that can permanently impair an investor’s lifestyle or ability to meet future liabilities.  Slow failure, on the other hand, occurs when an investor fails to grow their portfolio at a speed sufficient to offset inflation and withdrawals.

Investors have traditionally managed these risks through asset allocation, balancing exposure to growth-oriented asset classes (e.g. equities) with more conservative, risk-mitigating exposures (e.g. cash or bonds).  How these assets are balanced is typically governed by where an investor falls in their investment lifecycle and which risk has the greatest impact upon the probability of their future success.

For example, younger investors who have a large proportion of their future wealth tied up in human capital often have very little risk of failing fast, as they are not presently relying upon withdrawals from their investment capital. Evidence suggests that the risk of fast failure peaks for pre- and early-retirees, whose future lifestyle will be largely predicated upon the amount of capital they are able to maintain into early retirement.  Later-stage retirees, on the other hand, once again become subject to the risk of failing slow, as longer lifespans put greater pressure upon the initial retirement capital to last.

Trend equity strategies seek to address both risks simultaneously by maintaining equity exposure when trends are positive and de-risking the portfolio when trends are negative.  Empirical evidence suggests that such strategies may allow investors to harvest a significant proportion of the long-term equity risk premium while significantly reducing the impact of severe and prolonged drawdowns.

The Potential Hedging Properties of Trend Following

When investors buy stocks and bonds, they are exposing themselves to “systematic risk factors.”  These risk factors are the un-diversifiable uncertainties associated with any investment. For bearing these risks, investors expect to earn a reward.  For example, common equity is generally considered to be riskier than fixed income because it is subordinate in the capital structure, does not have a defined payout, and does not have a defined maturity date.  A rational investor would only elect to hold stocks over bonds, then, if they expected to earn a return premium for doing so.

Similarly, the historical premium associated with many active investment strategies are also assumed to be risk-based in nature.  For example, quantitatively cheap stocks have historically outperformed expensive ones, an anomaly called the “value factor.”  Cheap stocks may be trading cheaply for a reason, however, and the potential excess return earned from buying them may simply be the premium required by investors to bear the excess risk.

In many ways, an investor bearing risk can be thought of as an insurer, expecting to collect a premium over time for their willingness to carry risk that other investors are looking to offload.  The payoff profile for premiums generated from bearing risk, however, is concave in nature: the investor expects to collect a small premium over time but is exposed to potentially large losses (see Figure 1).  This approach is often called being “short volatility,” as the manifestation of risk often coincides with large (primarily negative) swings in asset values.

Even the process of rebalancing a strategic asset allocation can create a concave payoff structure.  By reallocating back to a fixed mixture of assets, an investor sells assets that have recently outperformed and buys assets that have recently underperformed, benefiting when the relative performance of investments mean-reverts over time.

When taken together, strategically allocated portfolios – even those with exposure to alternative risk premia – tend to combine a series of concave payoff structures. This implies that a correlation-based diversification scheme may not be sufficient for managing left-tail risk during bad times, as a collection of small premiums may not offset large losses.

In contrast, trend-following strategies “cut their losers short and let their winners run” by design, creating a convex payoff structure (see Figure 1).¹  Whereas concave strategies can be thought of as collecting an expected return premium for bearing risk, a convex payoff can be thought of as expecting to pay an insurance premium in order to hedge risk.  This implies that while concave payoffs benefit from stability, convex payoffs benefit from instability, potentially helping hedge portfolios against large losses at the cost of smaller negative returns during normal market environments.

Figure 1: Example Concave and Convex Payoff Structures; Profit in Blue and Loss in Orange

Source: Newfound Research.  For illustrative purposes only and not representative of any Newfound Research product or investment.

What is Trend Equity?

Trend equity strategies rely upon the empirical evidence² that performance tends to persist in the short-run: positive performance tends to beget further positive performance and negative performance tends to beget further negative performance.  The theory behind the evidence is that behavioral biases exhibited by investors lead to the emergence of trends.

In an efficient market, changes in the underlying value of an investment should be met by an immediate, commensurate change in the price of that investment. The empirical evidence of trends suggests that investors may not be entirely efficient at processing new information.  Behavioral theory suggests that investors anchor their views on prior beliefs, causing price to underreact to new information.  As price continues to drift towards fair value, herding behavior occurs, causing price to overreact and extend beyond fair value.  Combined, these effects cause a trend.

Trend equity strategies seek to capture this potential inefficiency by systematically investing in equities when they are exhibiting positively trending characteristics and divesting when they exhibit negative trends.  The potential benefit of this approach is that it can try to exploit two sources of return: (1) the expected long-term risk premium associated with equities, and (2) the convex payoff structure typically associated with trend-following strategies.

As shown in Figure 2, a hypothetical implementation of this strategy on large-cap U.S. equities has historically matched the long-term annualized return while significantly reducing exposure to both tails of the distribution.  This is quantified in Figure 3, which demonstrates a significant reduction in both the skew and kurtosis (“fat-tailedness”) of the return distribution.

Figure 2

Figure 3

	U.S. Large-Cap Equities	Trend Equity
Annualized Return	11.1%	11.6%
Volatility	16.9%	11.3%
Skewness	-1.4	0.0
Excess Kurtosis	2.2	-1.0

 Source: Newfound Research.  Return data relies on hypothetical indices and is exclusive of all fees and expenses.  Returns assume the reinvestment of all dividends.  Trend Equity invests in U.S. Large-Cap Equity when the prior month has a positive 12-1 month total return and in 3-month U.S. Treasury Bills otherwise.  The Trend Equity strategy does not reflect any strategy offered or managed by Newfound Research and was constructed exclusively for the purposes of this commentary.  It is not possible to invest in an index.  Past performance does not guarantee future results.

Implementing Trend Equity

With trend equity seeking to benefit from both the long-term equity risk premium and the convex payoff structure of trend-following, there are two obvious examples of how it can be implemented in the context of an existing strategic portfolio. The preference as to the approach taken will depend upon an investor’s goals.

Investors seeking to reduce risk in their portfolio may prefer to think of trend equity as a form of dynamically hedged equity, replacing a portion of their traditional equity exposure.  In this case, when trend equity is fully invested, the portfolio will match the original allocation profile; when the trend equity strategy is divested, the portfolio will be significantly underweight equity exposure.  The intent of this approach is to match the long-term return profile of equities with less realized risk.

On the other hand, investors seeking to increase their returns may prefer to treat trend equity as a pivot within their portfolio, funding the allocation by drawing upon both traditional stock and bond exposures.  In this case, when fully invested, trend equity will create an overweight to equity exposure within the portfolio; when divested, it will create an underweight.  The intent of this approach is to match the long-term realized risk profile of a blended stock/bond mix while enhancing long-term returns.

To explore these two options in the context of an investor’s lifecycle, we echo the work of Freccia, Rauseo, and Villalon (2017).  Specifically, we will begin with a naïve “own-your-age” glide path, which allocates a proportion of capital to bonds equivalent to the investor’s age.  We assume the split between domestic and international exposures is 60/40 and 70/30 respectively for stocks and bonds, selected to approximate the split between domestic and international exposures found in Vanguard’s Target Retirement Funds.

An investor seeking to reduce exposure to negative equity tail events could fund trend equity exposure entirely from their traditional equity allocation. Applying the own-your-age glide path over the horizon of June 1988 to June 2018, carving out 30% of U.S. equity exposure for trend equity (e.g. an 11.7% allocation for a 35 year old investor and an 8.1% allocation for a 55 year old investor) would have offered the same long-term return profile while reducing annualized volatility and the maximum drawdown experienced.

For an investor seeking to increase return, funding a position in trend equity from both U.S. equities and U.S. bonds may be a more applicable approach.  Again, applying the own-your-age glide-path from June 1988 to June 2018, we find that replacing 50% of existing U.S. equity exposure and 30% of existing U.S. bond exposure with trend equity would have offered a nearly identical long-term volatility profile while increasing long-term annualized returns.

Figure 4

Source: Newfound Research.  For illustrative purposes only and not representative of any Newfound Research product or investment.

 

Figure 5: Hypothetical Portfolio Statistics, June 1988 – June 2018

	Original Glidepath	Same Return, Decrease Risk	Increase Return, Same Risk
Annual Return	8.20%	8.25%	8.60%
Volatility	8.58%	8.17%	8.59%
Maximum Drawdown	-28.55%	-24.71%	-23.80%
Sharpe Ratio	0.61	0.64	0.65

 Source: Newfound Research.  Return data relies on hypothetical indices and is exclusive of all fees and expenses.  Returns assume the reinvestment of all dividends.  Trend Equity invests in U.S. Large-Cap Equity when the prior month has a positive 12-1 month total return and in 3-month U.S. Treasury Bills otherwise.  The Trend Equity strategy does not reflect any strategy offered or managed by Newfound Research and was constructed exclusively for the purposes of this commentary.  It is not possible to invest in an index.  Past performance does not guarantee future results.

 

Figure 6: Own-Your-Age Glide Paths Including Trend Equity

Source: Newfound Research.  For illustrative purposes only and not representative of any Newfound Research product or investment.  Allocation methodologies described in the preceding section.

A Discussion of Trade-Offs

At Newfound Research, we champion the philosophy that “risk cannot be destroyed, only transformed.”  While we believe that a convex payoff structure – like that empirically found in trend-following strategies – can introduce beneficial diversification into traditionally allocated portfolios, we believe any overview is incomplete without a discussion of the potential trade-offs of such an approach.

The perceived trade-offs will be largely dictated by how trend equity is implemented by an investor.  As in the last section, we will consider two cases: first the investor who replaces their traditional equity exposure, and second the investor that funds an allocation from both stocks and bonds.

In the first case, we believe that the convex payoff example displayed Figure 1 is important to keep in mind.  Traditionally, convex payoffs tend to pay a premium during stable environments.  When this payoff structure is combined with traditional long-only equity exposure to create a trend equity strategy, our expectation should be a return profile that is expected to lag behind traditional equity returns during calm market environments.

This is evident in Figure 7, which plots hypothetical rolling 3-year annualized returns for both large-cap U.S. equities and a hypothetical trend equity strategy. Figure 8 also demonstrates this effect, plotting rolling 1-year returns of a hypothetical trend equity strategy against large-cap U.S. equities, highlighting in orange those years when trend equity underperformed.

For the investor looking to employ trend equity as a means of enhancing return by funding exposure from both stocks and bonds, long-term risk statistics may be misleading.  It is important to keep in mind that at any given time, trend equity can be fully invested in equity exposure.  While evidence suggests that trend-following strategies may be able to act as an efficient hedge when market downturns are gradual, they are typically inefficient when prices collapse suddenly.

In both cases, it is important to keep in mind that convex payoff premium associated with trend equity strategies is not consistent, nor is the payoff guaranteed. In practice, the premium arises from losses that arrive during periods of trend reversals, an effect popularly referred to as “whipsaw.”  A trend equity strategy may go several years without experiencing whipsaw, seemingly avoiding paying any premium, then suddenly experience multiple back-to-back whipsaw events at once.  Investors who allocate immediately before a series of whipsaw events may be dismayed, but we believe that these are the costs necessary to access the convex payoff opportunity and should be considered on a multi-year, annualized basis.

Finally, it is important to consider that trend-following is an active strategy. Beyond management fees, it is important to consider the impact of transaction costs and taxes.

Figure 7Source: Newfound Research.  Return data relies on hypothetical indices and is exclusive of all fees and expenses. Returns assume the reinvestment of all dividends.  Trend Equity invests in U.S. Large-Cap Equity when the prior month has a positive 12-1 month total return and in 3-month U.S. Treasury Bills otherwise.   The Trend Equity strategy does not reflect any strategy offered or managed by Newfound Research and was constructed exclusively for the purposes of this commentary.  It is not possible to invest in an index.  Past performance does not guarantee future results.

Figure 8

Source: Newfound Research.  Return data relies on hypothetical indices and is exclusive of all fees and expenses. Returns assume the reinvestment of all dividends.  Trend Equity invests in U.S. Large-Cap Equity when the prior month has a positive 12-1 month total return and in 3-month U.S. Treasury Bills otherwise.   The Trend Equity strategy does not reflect any strategy offered or managed by Newfound Research and was constructed exclusively for the purposes of this commentary.  It is not possible to invest in an index.  Past performance does not guarantee future results.

Conclusion

In this primer, we have introduced trend equity, an active strategy that seeks to provide investors with exposure to the equity risk premium while mitigating the impacts of severe and prolonged drawdowns.  The strategy aims to achieve this objective by blending exposure to equities with the convex payoff structure traditionally exhibited by trend-following strategies.

We believe that such a strategy can be a particularly useful diversifier for most strategically allocated portfolios, which tend to be exposed to the concave payoff profile of traditional risk factors.  While relying upon correlation may be sufficient in normal market environments, we believe that the potential premiums collected can be insufficient to offset large losses generated during bad times.  It is during these occasions that we believe a convex payoff structure, like that empirically found in trend equity, can be a particularly useful diversifier.

We explored two ways in which investors can incorporate trend equity into a traditional profile depending upon their objective.  Investors looking to reduce realized risk without necessarily sacrificing long-term return can fund their trend equity exposure with their traditional equity allocation.  Investors looking to enhance returns while maintaining the same realized risk profile may be better off funding exposure from both traditional stock and bond allocations.

Finally, we discussed the trade-offs associated with incorporating trend equity into an investor’s portfolio, including (1) the lumpy and potentially large nature of whipsaw events, (2) the inability to hedge against sudden losses, and (3) the costs associated with managing an active strategy.  Despite these potential drawbacks, we believe that trend-following equity can be a potentially useful diversifier in most traditionally allocated portfolios.

Bibliography

Freccia, Maxwell, and Rauseo, Matthew, and Villalon, Daniel, DC Solutions Series: Defensive Equity, Part 2.  Available at https://www.aqr.com/Insights/Research/DC-Solutions/DC-Solutions-Series-Defensive-Equity-Part-2.  Accessed September 2018.

Hsieh, David A. and Fung, William, The Risk in Hedge Fund Strategies: Theory and Evidence from Trend Followers. The Review of Financial Studies, Vol. 14, No. 2, Summer 2001. Available at SSRN: https://ssrn.com/abstract=250542

Hurst, Brian and Ooi, Yao Hua and Pedersen, Lasse Heje, A Century of Evidence on Trend-Following Investing (June 27, 2017). Available at SSRN: https://ssrn.com/abstract=2993026 or http://dx.doi.org/10.2139/ssrn.2993026

Lempérière, Yves, and Deremble, Cyril and Seager, Philip and Potters, Marc, and Bouchaud, Jean-Phillippe. (April, 2014), Two Centuries of Trend Following, Journal of Investment Strategies, 3(3), pp. 41-61.

1. Fung and Hsieh (2001) find that “trend followers have nonlinear, option-like trading strategies,” and that the payoff structure resembles that of a lookback straddle option.
2. Both Lempérière et al. (2014) and Hurst et al. (2014) create backtests for trend-following strategies extending more than a century and find significant evidence of its efficacy across multiple different asset classes and study periods.