This post is available as a PDF download here.

What is Trend Equity?

Trend equity strategies seek to meaningfully participate with equity market growth while side-stepping significant and prolonged drawdowns.  These strategies aim to achieve this goal by dynamically adjusting market exposure based upon trend-following signals.

A naïve example of such a strategy would be a portfolio that invests in U.S. equities when the prior 1-year return for U.S. equities is positive and divests entirely into short-term U.S. Treasuries when it is negative.

The Theory

This category of strategies relies upon the empirical evidence 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 (Figure I) 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.

The Positive Convexity of Trend Following

As shown in Figure II, we can see that a hypothetical implementation of this strategy on large-cap U.S. equities has historically exhibited a convex return profile with respect to the underlying U.S. equity index, meaningfully participating in positive return years while reducing exposure to significant loss years.

“Risk Cannot Be Destroyed, Only Transformed.”

While the flexibility of trend equity strategies gives them the opportunity to both protect and participate, it also creates the potential for losses due to “whipsaw.”  Whipsaws occur when the strategy changes positioning due to what appears to be a change in trend, only to have the market rapidly reverse course.  Such a scenario can lead to ”buy high, sell low” and “sell low, buy high” scenarios.  These scenarios can be exacerbated by the fact that trend equity strategies may go several years without experiencing whipsaw to only then suddenly experience multiple back-to-back whipsaw events at once.

As Defensive Equity

The most obvious implementation of trend equity strategies is within a defensive equity sleeve.  In this approach, an allocation for the strategy is funded by selling strategic equity exposure (see Figure III).  Typically combined with other defensive styles (e.g. minimum volatility, quality, et cetera), the goal of a defensive equity sleeve is to provide meaningful upside exposure to equity market growth while reducing downside risk.

This implementation approach has the greatest potential to reduce a policy portfolio’s exposure to downside equity risk and therefore may be most appropriate for investors for whom ”failing fast” is a critical threat.  For example, pre-retirees, early retirees, and institutions making consistent withdrawals are highly subject to sequence risk and large drawdowns within their portfolios can create significant impacts on portfolio sustainability.

The drawback of a defensive equity implementation is that vanilla trend equity strategies can, at best, keep up with their underlying index during strong bull markets (see Figure IV).  Given the historical evidence that markets tend to be up more frequently than they are down, this can make this approach a frustrating one to stick with for investors.  Furthermore, up-capture during bull markets can be volatile on a year-to-year basis, with low up-capture during whipsaw periods and strong up-capture during years with strong trends.  Therefore, investors should only allocate in this manner if they plan to do so over a full market cycle.

Implementation within a Defensive Equity sleeve may also be a prudent approach with investors for whom their risk appetite is far below their risk capacity (or even need); i.e. investors who are chronically under-allocated to equity exposure.  Implementation of a strategy that has the ability to pro-actively de-risk may allow investors to feel more comfortable with a larger exposure.

Finally, this approach may also be useful for investors seeking to put a significant amount of capital to work at once.  While evidence suggests that lump-sum investing (“LSI”) almost always out-performs dollar cost averaging (”DCA”), investors may feel uncomfortable with the significant timing luck from LSI.  One potential solution is to utilize trend equity as a middle ground; for example, investors could DCA but hold trend equity rather than cash.

Pros

  • Maintains overall strategic allocation policy.
  • May help risk-averse investors more confidently maintain an appropriate risk profile.
  • May provide meaningful reduction in exposure to significant and prolonged equity losses.

Cons

  • High year-to-year tracking error relative to traditional equity benchmarks.
  • Typically under-performs equities during prolonged bull markets (see Figure IV).

As a Tactical Pivot

One creative way of implementing a trend equity strategy is as a tactical pivot within a portfolio.  In this implementation, an allocation to trend equity is funded by selling both stocks and bonds, typically in equal amounts (see Figure V).  By implementing in this manner, the investor’s portfolio will pivot around the policy benchmark, being more aggressively allocated when trend equity is fully invested, and more defensively allocated when trend equity de-risks.

This approach is often appealing because it offers a highly intuitive allocation sizing policy.  The size of the tactical pivot sleeve as well as the mixture of stocks and bonds used to fund the sleeve defines the tactical range around the strategic policy portfolio (see Figure VI).

One benefit of this implementation is that trend equity no longer needs to out-perform an equity benchmark to add value.  Rather, so long as the strategy outperforms the mixture of stocks and bonds used to fund the allocation (e.g. a 50/50 mix), the strategy can add value to the holistic portfolio design.  For example, assume a trend equity strategy only achieves an 80% upside capture to an equity benchmark during a given year.  Implemented as a defensive equity allocation, this up-capture would create a drag on portfolio returns relative to the policy benchmark.  If, however, trend equity is implemented as a tactical pivot – funded, for example, from a 50/50 mixture of stocks and bonds – then so long as it outperformed the funding mixture, the portfolio return is improved due to its tilt towards equities.

Implementation as a tactical pivot can also add potential value during environments where stocks and bonds exhibit positive correlations and negative returns (e.g. the 1970s).

One potential drawback of this approach is that the portfolio can be more aggressively allocated than the policy benchmark during periods of sudden and large declines.  How great a risk this represents will be dictated both by the size of the tactical pivot as well as the ratio of stocks and bonds in the funding mixture.  For example, the potential overweight towards equities is significantly lower using a 70/30 stock/bond funding mix than a 30/70 mixture.  A larger allocation to bonds in the funding mixture creates a higher downside hurdle rate for trend equity to add value during a negative equity market environment.

Pros

  • Lower hurdle rate for strategy to add value to portfolio during positive equity environments.
  • Intuitive allocation policy based on desired level of tactical tilts within the portfolio.
  • May provide cushion in environments where stocks and bonds are positively correlated.

Cons

  • Portfolio may be allocated above benchmark policy to risky assets during a sudden market decline.
  • Higher hurdle rate for strategy to add value to portfolio during negative equity environments.

As a Liquid Alternative

Due to its historically convex return profile and potentially high level of tracking error exhibited over short measurement horizons, trend equity may also be a natural fit within a portfolio’s alternative sleeve.  Indeed, when analyzed more thoroughly, trend equity shares many common traits with other traditionally alternative strategies.

For example, a vanilla trend equity implementation can be decomposed into two component sources of returns: a strategic portfolio and a long/short trend-following overlay.  Trend following can also be directly linked to the dynamic trading strategy required to replicate a long option position.

There are even strong correlations to traditional alternative categories.  For example, a significant driver of returns in equity hedge and long/short equity categories is dynamic market beta exposure, particularly during significant market declines (see Figure VII).  Trend equity strategies that are implemented with factor-based equity exposures or with the flexibility to make sector and geographic tilts may even more closely approximate these categories.

One potential benefit of this approach is that trend equity can be implemented in a highly liquid, highly transparent, and cost-effective manner when compared against many traditional alternatives.  Furthermore, by implementing trend equity within an alternatives sleeve, investors may give it a wider berth in their mental accounting of tracking error, allowing for a more sustainable allocation versus implementation as a defensive equity solution.

A drawback of this implementation, however, is that trend equity will increase a portfolio’s exposure to equity beta.  Therefore, more traditional alternatives may offer better correlation- and pay-off-based diversification, especially during sudden and large negative equity shocks.  Furthermore, trend equity may lead to overlapping exposures with existing alternative exposures such as equity long/short or managed futures.  Investors must therefore carefully consider how trend equity may fit into an already existing alternative sleeve.

Pros

  • Highly transparent, easy-to-understand investment process.
  • Implemented with highly liquid underlying exposures.
  • Investors often given alternatives a wider berth of allowable tracking error than more traditional allocations.

Cons

  • May be more highly correlated with existing portfolio exposures than other alternatives.
  • Potentially overlapping exposure with existing alternatives such as equity long/short or managed futures.

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.