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Global Growth-Trend Timing

This post is available as a PDF download here.


  • While trend following may help investors avoid prolonged drawdowns, it is susceptible to whipsaw where false signals cause investors to either buy high and sell low (realizing losses) or sell low and buy high (a missed opportunity).
  • Empirical evidence suggests that using economic data in the United States as a filter of when to employ trend-following – a “growth-trend timing” model – has historically been fruitful.
  • When evaluated in other countries, growth-trend timing has been historically successful in mitigating whipsaw losses without sacrificing the ability to avoid large drawdowns. However, we see mixed results on whether this actually improves upon naïve trend-following.
  • We find that countries that can be influenced by factors originating outside of their borders might not benefit from an introspective economic signal.

We apologize in advance, as this commentary will be fairly graph- and table-heavy.

We have written fairly extensively on the topic of factor-timing in the past, and much of the success has been proven to be both hard to implement and recreate out of sample.

One of the inherent pains of trend following is the existence of whipsaws, or more precisely, the misidentification of perceived market trends, which turn out to be more noise than signal. An article from Philosophical Economics proposed using several economic indicators to tune down the noise that might affect price-driven signals such as trend following.  Generally, this strategy imposed an overlay that turned trend following “on” when the change in the economic indicators were negative year-over-year signaling a higher likelihood of recession, and conversely, adopted a buy-and-hold stance when the economic indicators were not flashing warning lights.

This strategy presents a certain appeal as leading economic indicators may, as their name implies, lead the market for some time until capital preservation is warranted.  Switching to a trend-following approach may allow a strategy to continue to participate in market appreciation while it lasts.  On the other hand, using economic confirmation as a filter may help a strategy avoid the whipsaw costs generated from noisy market dips while positive economic conditions persist.

In an effort to test such a strategy out-of-sample, we took the approach global, hoping to capture a broader cross-section of economic and market environments.

First, we will consider trend following with no timing using the economic indicators.1

Below we plot the equity curves for Australia, Germany, Italy, Japan, Singapore, the United Kingdom, and the United States, alongside a strategy that is long the market when the market is above the trailing twelve-month average (“12 Month average”) and steps to cash when the price is below it.  The ratio between the two is also included to show the relative cumulative performance between the trend strategy and the respective market. An increasing ratio means that the trend following strategy is adding value over buy-and-hold.

Source: MSCI, Global Financial Data.  Calculations by Newfound Research.  Past performance is not an indicator of future results.  Performance is backtested and hypothetical.  Performance figures are gross of all fees, including, but not limited to, manager fees, transaction costs, and taxes.  Performance assumes the reinvestment of all distributions. 

Through the graphs above, it becomes clear that much of the trend premium is realized by avoiding the large, prolonged bear markets that tend to occur during economic distress.  In between these periods, however, the trend strategy lags the market. It makes sense, then, that a potential improvement to this strategy would be to implement an augmentation that could better distinguish between real price break-outs and those that lead to a whipsaw in the portfolio.

Growth-Trend Timing

For each country, we look at a number of economic indicators, including: corporate earnings growth, employment, housing starts, industrial production, and retail sales growth.2  The strategy then followed the same rules as described above: if the economic indicator in question displays a negative percentage change over the previous twelve-month period, a position is taken in a trend following strategy utilizing a twelve-month moving average signal.  Otherwise, a buy-and-hold position is established.

To ensure that we are not benefitting from look-ahead bias, a lag of three months was imposed on each of the economic indicators, as it would be unrealistic to assume that the economic levels would be known at the end of each month.

Unfortunately, some of the economic data points could not be found for the entire period in which prices are available, though the analysis can still prove beneficial by indicating what economic regimes trend following is benefitted by growth-trend timing, or the potential identification where one indicator may work when another does not.3

In the charts below, we plot the growth-trend timing (referred to as GTT for the remainder of this commentary) for each country utilizing the available signals. The charts represent the relative cumulative performance over the respective country’s market return.  For example, when the lines remain flat, the GTT approach has adopted buy-and-hold exposure and therefore matches the respective market’s returns. Any changes in the ratios are due to the GTT strategy investing in the trend following strategy.

Source: MSCI, Global Financial Data, St. Louis Fed, Bloomberg.  Calculations by Newfound Research.  Past performance is not an indicator of future results.  Performance is backtested and hypothetical.  Performance figures are gross of all fees, including, but not limited to, manager fees, transaction costs, and taxes.  Performance assumes the reinvestment of all distributions. 

What we see from the above figures is a mixed bag of results.

The overlay of economic indicators was by far successful in the mitigation of whipsaw losses, as each country reaped the benefits of being primarily long the market during bull markets. As the 12-month moving average strategy tended to slowly give up a portion of the gains realized from severe market environments, the majority of the GTT strategies remained relatively stagnant until the next major correction.

There are some instances, however, where the indicator was late to the economic party.  It is worth remembering that the market is, in theory, a forward-looking measure, and therefore sudden economic shocks may not be captured in economic data as quickly as it is in market returns.  This created cases where the strategy either missed the chance to be out of the market during a correction or was sitting on the sidelines during the subsequent recoveries. Notably, the employment signal in Australia, Italy, Singapore, and the United Kingdom tended to be a poor leading indicator as the strategy tended to be invested longer in the bear markets than the trend strategy.


A Candidate for Ensembling

The implicit assumption in the analysis above is that the included indicators behave in similar ways.  For example, by using a twelve-month lookback period for the indicators, we are assuming that each indicator will begin to trend in roughly the same way.

That may not be a particularly fair assumption.  Whereas housing starts and retail sales are generally considered leading indicators, employment (unemployment) rates are normally categorized as lagging indicators. For this reason, it may be more beneficial to use a shorter lookback period so as to pick up on potential problems in the economy as they begin to present themselves.  Further, some signals tend to be more erratic than others, suggesting that a meaningful lookback period for one indicator may not be meaningful for another. With no perfect reason to prefer one lookback over another, we might consider different lookback periods so as to diversify any specification risk that may exist within the strategy.

With the benefit of hindsight, we know that not all recessions occur for the same reasons, so being reliant on one signal that has worked in the past may not be as beneficial in the future. With this in mind, we should consider that all indicators hold some information as to the state of the economy since one indicator may be signaling the all-clear while another may be flashing warning lights.

For the same reason medical professionals take multiple readings to gain insight into the state of the body, we should also consider any available signals to ascertain the health of the economy.

To ensemble this strategy, we will vary the lookbacks from six to eighteen months, while holding the lag at three months, as well as combine the available economic signals for each country.  For the sake of brevity, we will hold the trend-following strategy the same with a twelve-month moving average.

Remember, if the economic signal is negative, it does not mean that we are immediately out of the market: a negative economic signal simply moves the strategy into a trend-following approach. With 5 economic indicators and 13 lookback periods, we have 65 possible strategies for each country. As an example, if 40 of these 65 models were positive and 25 were negative, we would hold 62% in the market and 38% in the trend following strategy.

The resulting performance statistics can be seen in the table below.

Source: MSCI, Global Financial Data, St. Louis Fed, Bloomberg.  Calculations by Newfound Research.  Past performance is not an indicator of future results.  Performance is backtested and hypothetical.  Performance figures are gross of all fees, including, but not limited to, manager fees, transaction costs, and taxes.  Performance assumes the reinvestment of all distributions. 

From the table above, we see that there are, again, mixed results. One country that particularly stands out is Italy in that the sign on its return flipped to negative and the drawdown was actually deeper with GTT than with a simple buy-and-hold strategy.

Source: MSCI, Global Financial Data, St. Louis Fed, Bloomberg.  Calculations by Newfound Research.  Past performance is not an indicator of future results.  Performance is backtested and hypothetical.  Performance figures are gross of all fees, including, but not limited to, manager fees, transaction costs, and taxes.  Performance assumes the reinvestment of all distributions. 

Digging deeper, it appears that the GTT strategy for Italy was actually whipsawed by more than just trend-following. Housing start data for Italy was not readily available until December 2008, so Italy may have been at a relative disadvantage when compared against the other countries.  Since the reliable data we could find begins at the end of 2008 and the majority of the whipsaw losses occur post-Great Financial Crisis, we can run the analysis again, but with housing start data being added in upon its availability.

Source: MSCI, Global Financial Data, St. Louis Fed, Bloomberg.  Calculations by Newfound Research.  Past performance is not an indicator of future results.  Performance is backtested and hypothetical.  Performance figures are gross of all fees, including, but not limited to, manager fees, transaction costs, and taxes.  Performance assumes the reinvestment of all distributions. 

Adding housing starts in as an indicator did not meaningfully alter the results over the period. One hypothesis is that the indicators included could not fully encapsulate the complex state of Italy’s economy over the period.  Italy has weathered three technical recessions over the past decade, so this could be a regime where the market is looking to sources outside the country for indications of distress or where the economic indicator is not reflective of the pressures driving the market.

Source: MSCI, St. Louis Fed.  Calculations by Newfound Research.  Past performance is not an indicator of future results.  Performance is backtested and hypothetical.  Performance figures are gross of all fees, including, but not limited to, manager fees, transaction costs, and taxes.  Performance assumes the reinvestment of all distributions. 

Above, we can see several divergences between the market movement and changes in real GDP. Specifically, in the past decade, we see that the market reacted to information that didn’t materialize in the country’s real GDP. More likely, the market was reacting to regional financial distress driven by debt concerns.

The MSCI Italy index is currently composed of 24 constituents with multinational business operations. Additionally, the index maintains large concentrations in financials, utilities, and energy: 33%, 25%, and 14%, respectively.4  Because of this sector concentration, utilizing the economic indicators may overly focus on the economic health of Italy while ignoring external factors such as energy prices or broader financial distress that could be swaying the market needle.

A parallel explanation could be that the Eurozone is entangled enough that signals could be interfering with each other between countries. Further research could seek to disaggregate signals between the Eurozone and the member-countries, attempting to differentiate between zone, regional, and country signals to ascertain further meaning.

Additionally, economic indicators are influenced by both the private and public sector so this could represent a disconnect between public company health and private company health.


In this commentary, we sought to answer the question, “can we improve trend-following by drawing information from a country’s economy”. It intuitively makes sense that an investor would generally opt for remaining in the market unless there are systemic issues that may lead to market distress.  A strategy that successfully differentiates between market choppiness and periods of potential recession would drastically mitigate any losses incurred from whipsaw, thereby capturing a majority of the equity premium as well as the trend premium.

We find that growth-trend timing has been relatively successful in countries such as the United States, Germany, and Japan.  However, the country that is being analyzed should be considered in light of their specific circumstances.

Peeking under the hood of Italy, it becomes clear that market movements may be influenced by more than a country’s implicit economic health.  In such a case, we should pause and ask ourselves whether a macroeconomic indicator is truly reflective of that country’s economy or if there are other market forces pulling the strings.



Macro Timing with Trend Following

This post is available for download here.


  • While it may be tempting to time allocations to active strategies, it is generally best to hold them as long-term allocations.
  • Despite this, some research has shown that there may be certain economic environments where trend following equity strategies are better suited.
  • In this commentary, we replicate this data and find that a broad filter of recessionary periods does indeed show this for certain trend equity strategies but not for the style of trend equity in general.
  • However, further decomposing the business cycle into contractions, recoveries, expansions, and slowdowns using leading economic indicators such as PMI and unemployment does show some promising relationships between the forecasted stage of the business cycle and trend following’s performance relative to buy-and-hold equities.
  • Even if this data is not used to time trend equity strategies, it can be beneficial to investors for setting expectations and providing insight into performance differences.

Systematic active investing strategies are a way to achieve alternative return profiles that are not necessarily present when pursuing standard asset allocation and may therefore play an important role in developing well-diversified portfolios.

But these strategies are best viewed as allocations rather than trades.1 This is a topic we’ve written about a number of times with respect to factor investing over the past several years, citing the importance of weathering short-term pain for long-term gains. For active strategies to outperform, some underperformance is necessary. Or, as we like to say, “no pain, no premium.”

That being said, being tactical in our allocations to active strategies may have some value in certain cases. In one sense, we can view the multi-layered active decisions simply as another active strategy, distinct from the initial one.

An interesting post on Philosophical Economics looked at using a variety of recession indicators (unemployment, earnings growth, industrial production, etc.) as ways to systematically invest in either U.S. equities or a trend following strategy on U.S. equities. If the economic indicator was in a favorable trend, the strategy was 100% invested in equities. If the economic indicator was in an unfavorable trend, the strategy was invested in a trend following strategy applied to equities, holding cash when the market was in a downtrend.

The reasoning behind this strategy is intuitively appealing. Even if a recession indicator flags a likely recession, the market may still have room to run before turning south and warranting capital protection. On the other hand, when the recession indicator was favorable, purely investing in equities avoids some of the whipsaw costs that are inherent in trend following strategies.

In this commentary, we will first look at the general style of trend equity in the context of recessionary and non-recessionary periods and then get a bit more granular to see when trend following has worked historically through the economic cycle of Expansion, Slowdown, Contraction, and Recovery.

Replicating the Data

To get our bearings, we will first attempt to replicate some of the data from the Philosophical Economics post using only the classifications of “recession” and “not-recession”.

Keeping in line with the Philosophical Economics method, we will use whether the economic metric is above or below its 12-month moving average as the recession signal for the next month. We will use market data from the Kenneth French Data Library for the total U.S. stock market returns and the risk-free rate as the cash rate in the equity trend following model.

The following table shows the results of the trend following timing models using the United States ISM Purchasing Managers Index (PMI) and the Unemployment Rate as indicators.

U.S. Equities12mo MA Trend Equity12m MA Trend Timing Model (PMI)12mo MA Trend Timing Model (Unemployment)
Annualized Return11.3%11.1%11.3%12.2%
Annualized Volatility14.7%11.2%11.9%12.4%
Maximum Drawdown50.8%24.4%32.7%30.0%
Sharpe Ratio0.490.620.610.66

Source: Quandl and U.S. Bureau of Labor Statistics. Calculations by Newfound Research. Results are hypothetical. Results assume the reinvestment of all distributions. Results are gross of all fees, including, but not limited to, manager fees, transaction costs, and taxes. Past performance is not an indicator of future results. You cannot invest in an index. Data is from Jan 1948 – Sep 2019.

With the trend timing model, we see an improvement in the absolute returns compared to the trend equity strategy alone. However, this comes at the expense of increasing the volatility and maximum drawdown.

In the case of unemployment, which was the strongest indicator that Philosophical Economics found, there is an improvement in risk-adjusted returns in the timing model.

Still, while there is a benefit, it may not be robust.

If we remove the dependence of the trend following model on a single metric or lookback parameter, the benefit of the macro-timing decreases. Specifically, if we replace our simple 12-month moving average trend equity rule with the ensemble approach utilized in the Newfound Trend Equity Index, we see very different results. This may indicate that one specific variant of trend following did well in this overall model, but the style of trend following might not lend itself well to this application.

U.S. EquitiesNewfound Trend Equity IndexTrend Equity Index Blend (PMI)Trend Equity Index Blend (Unemployment)
Annualized Return11.3%10.7%10.9%10.9%
Annualized Volatility14.7%11.1%11.8%13.5%
Maximum Drawdown50.8%25.8%36.1%36.0%
Sharpe Ratio0.490.590.580.50

Source: Quandl and U.S. Bureau of Labor Statistics. Calculations by Newfound Research. Results are hypothetical. Results assume the reinvestment of all distributions. Results are gross of all fees, including, but not limited to, manager fees, transaction costs, and taxes. Past performance is not an indicator of future results. You cannot invest in an index. Data is from Jan 1948 – Sep 2019.

A more robust trend following model may already provide more upside capture during non-recessionary periods but at the expense of more downside capture during recessions. However, we cannot confidently assert that the lower level of down-capture in the single specification of the trend model is not partially due to luck.

If we desire to more thoroughly evaluate the style of trend following, we must get more granular with the economic cycles.

Breaking Down the Economic Cycle

Moving beyond the simple classification of “recession” and “not-recession”, we can follow MSCI’s methodology, which we used here previously, to classify the economic cycle into four primary states: Expansion, Slowdown, Contraction and Recovery.

We will focus on the 3-month moving average (“MA”) minus the 12-month MA for each indicator we examine according to the decision tree below. In the tree, we use the terms better or worse since lower unemployment rate and higher PMI values signal a stronger economy.

Economic cycle

There is a decent amount of difference in the classifications using these two indicators, with the unemployment indicator signaling more frequent expansions and slowdowns. This should be taken as evidence that economic regimes are difficult to predict.

Source: Quandl and U.S. Bureau of Labor Statistics. Calculations by Newfound Research. Results are hypothetical. Results assume the reinvestment of all distributions. Results are gross of all fees, including, but not limited to, manager fees, transaction costs, and taxes. Past performance is not an indicator of future results. You cannot invest in an index. Data is from Jan 1948 – Sep 2019.

Once each indicator is in each state the transition probabilities are relatively close.

Source: Quandl and U.S. Bureau of Labor Statistics. Calculations by Newfound Research. Results are hypothetical. Past performance is not an indicator of future results.

This agrees with intuition when we consider the cyclical nature of these economic metrics. While not a perfect mathematical relationship, these states generally unfold sequentially without jumps from contractions to expansions or vice versa.

Trend Following in the Economic Cycle

Applying the four-part classification to the economic cycle shows where trend equity outperformed.

PMI IndicatorUnemployment Indicator
U.S. EquitiesTrend EquityU.S. EquitiesTrend Equity

Source: Quandl and U.S. Bureau of Labor Statistics. Calculations by Newfound Research. Results are hypothetical. Results assume the reinvestment of all distributions. Results are gross of all fees, including, but not limited to, manager fees, transaction costs, and taxes. Past performance is not an indicator of future results. You cannot invest in an index. Data is from Jan 1948 – Sep 2019.

During contraction phases, regardless of indicators, trend equity outperformed buy-and-hold.

For the PMI indicator, trend equity was able to keep up during expansions, but this was not the case with the unemployment indicator. The reverse of this was true for recoveries: trend following was close to keeping up in the periods denoted by the unemployment indicator but not by the PMI indicator.

For both indicators, trend following underperformed during slowdowns.

This may seem contradictory at first, but these may be periods of more whipsaw as markets try to forecast future states. And since slowdowns typically occur after expansions and before contractions (at least in the idealized model), we may have to bear more of this whipsaw risk for the strategy to be adaptable enough to add value during the contraction.

The following two charts show the longest historical slowdowns for each indicator: the PMI indicator was for 11 months in late 2009 through much of 2010 and the unemployment rate indicator was for 16 months in 1984-85.

Source: Quandl and U.S. Bureau of Labor Statistics. Calculations by Newfound Research. Results are hypothetical. Results assume the reinvestment of all distributions. Results are gross of all fees, including, but not limited to, manager fees, transaction costs, and taxes. Past performance is not an indicator of future results. You cannot invest in an index.

In the first slowdown period, the trend equity strategy rode in tandem with equities as they continued to climb and then de-risked when equities declined. Equities quickly rebounded leaving the trend equity strategy underexposed to the rally.

In the second slowdown period, the trend equity strategy was heavily defensive going into the slowdown. This protected capital initially but then caused the strategy to lag once the market began to increase steadily.

The first period illustrates a time when the trend equity strategy was ready to adapt to changing market conditions and was unfortunately whipsawed. The second period illustrates a time when the trend equity strategy was already adapted to a supposedly oncoming contraction that did not materialize.

Using these historical patterns of performance, we can now explore how a strategy that systematically allocates to trend equity strategies might be constructed.

Timing Trend Following with the Economic Cycle

One simple way to apply a systematic timing strategy for shifting between equities and trend following is to only invest in equities when a slowdown is signaled.

The charts below show the returns and risk metrics for models using the PMI and unemployment rate individually and a model that blends the two allocations.

Growth trend timing

Source: Quandl and U.S. Bureau of Labor Statistics. Calculations by Newfound Research. Results are hypothetical. Results assume the reinvestment of all distributions. Results are gross of all fees, including, but not limited to, manager fees, transaction costs, and taxes. Past performance is not an indicator of future results. You cannot invest in an index. Data is from Jan 1948 – Sep 2019.

Source: Quandl and U.S. Bureau of Labor Statistics. Calculations by Newfound Research. Results are hypothetical. Results assume the reinvestment of all distributions. Results are gross of all fees, including, but not limited to, manager fees, transaction costs, and taxes. Past performance is not an indicator of future results. You cannot invest in an index. Data is from Jan 1948 – Sep 2019.

The returns increased slightly in every model relative to buy-and-hold, and the blended model performed consistently high across all metrics.

Blending multiple models generally produces benefits like these shown here, and in an actual implementation, utilizing additional economic indicators may make the strategy even more robust. There may be other ways to boost performance across the economic cycle, and we will explore these ideas in future research.


Should investors rotate in and out of active strategies?

Not in most cases, since the typical drivers are short-term underperformance that is a necessary component of active strategies.

However, there may be opportunities to make allocation tweaks based on the economic cycle.

The historical data suggests that a specification-neutral trend-equity strategy has outperformed buy-and-hold equities during economic contractions for both economic indicators. The performance during recoveries and expansions was mixed across indicators. It kept up with the buy-and-hold strategy during expansions denoted by PMI but not unemployment. This relationship was reversed for recoveries denoted by unemployment. In both models, trend equity has also lagged during economic slowdowns as whipsaw becomes more prevalent.

Based on the most recent PMI data, the current cycle is a contraction, indicating a favorable environment for trend equity under both cycle indicators. However, we should note that December 2018 through March 2019 was also labeled as a contraction according to PMI. Not all models are perfect.

Nevertheless, there may be some evidence that trend following can provide differentiated benefits based on the prevailing economic environment.

While an investor may not use this knowledge to shift around allocations to active trend following strategies, it can still provide insight into performance difference relative to buy-and-hold and set expectations going forward.

The Speed Limit of Trend

This post is available as a PDF download here.


  • Trend following is “mechanically convex,” meaning that the convexity profile it generates is driven by the rules that govern the strategy.
  • While the convexity can be measured analytically, the unknown nature of future price dynamics makes it difficult to say anything specific about expected behavior.
  • Using simulation techniques, we aim to explore how different trend speed models behave for different drawdown sizes, durations, and volatility levels.
  • We find that shallow drawdowns are difficult for almost all models to exploit, that faster drawdowns generally require faster models, and that lower levels of price volatility tend to make all models more effective.
  • Finally, we perform historical scenario analysis on U.S. equities to determine if our derived expectations align with historical performance.

We like to use the phrase “mechanically convex” when it comes to trend following.  It implies a transparent and deterministic “if-this-then-that” relationship between the price dynamics of an asset, the rules of a trend following, and the performance achieved by a strategy.

Of course, nobody knows how an asset’s future price dynamics will play out.  Nevertheless, the deterministic nature of the rules with trend following should, at least, allow us to set semi-reasonable expectations about the outcomes we are trying to achieve.

A January 2018 paper from OneRiver Asset Management titled The Interplay Between Trend Following and Volatility in an Evolving “Crisis Alpha” Industry touches precisely upon this mechanical nature.  Rather than trying to draw conclusions analytically, the paper employs numerical simulation to explore how certain trend speeds react to different drawdown profiles.

Specifically, the authors simulate 5-years of daily equity returns by assuming a geometric Brownian motion with 13% drift and 13% volatility.  They then simulate drawdowns of different magnitudes occurring over different time horizons by assuming a Brownian bridge process with 35% volatility.

The authors then construct trend following strategies of varying speeds to be run on these simulations and calculate the median performance.

Below we re-create this test.  Specifically,

  • We generate 10,000 5-year simulations assuming a geometric Brownian motion with 13% drift and 13% volatility.
  • To the end of each simulation, we attach a 20% drawdown simulation, occurring over T days, assuming a geometric Brownian bridge with 35% volatility.
  • We then calculate the performance of different NxM moving-average-cross-over strategies, assuming all trades are executed at the next day’s closing price. When the short moving average (N periods) is above the long moving average (M periods), the strategy is long, and when the short moving average is below the long moving average, the strategy is short.
  • For a given T-day drawdown period and NxM trend strategy, we report the median performance across the 10,000 simulations over the drawdown period.

By varying T and the NxM models, we can attempt to get a sense as to how different trend speeds should behave in different drawdown profiles.

Note that the generated tables report on the median performance of the trend following strategy over only the drawdown period.  The initial five years of positive expected returns are essentially treated as a burn-in period for the trend signal.  Thus, if we are looking at a drawdown of 20% and an entry in the table reads -20%, it implies that the trend model was exposed to the full drawdown without regard to what happened in the years prior to the drawdown.  The return of the trend following strategies over the drawdown period can be larger than the drawdown because of whipsaw and the fact that the underlying equity can be down more than 20% at points during the period.

Furthermore, these results are for long/short implementations.  Recall that a long/flat strategy can be thought of as 50% explore to equity plus 50% exposure to a long/short strategy.  Thus, the results of long/flat implementations can be approximated by halving the reported result and adding half the drawdown profile.  For example, in the table below, the 20×60 trend system on the 6-month drawdown horizon is reported to have a drawdown of -4.3%.  This would imply that a long/flat implementation of this strategy would have a drawdown of approximately -12.2%.

Calculations by Newfound Research.  Results are hypothetical.  Returns are gross of all fees, including manager fees, transaction costs, and taxes.

There are several potential conclusions we can draw from this table:

  1. None of the trend models are able to avoid an immediate 1-day loss.
  2. Very-fast (10×30 to 10×50) and fast (20×60 and 20×100) trend models are able to limit losses for week-long drawdowns, and several are even able to profit during month-long drawdowns but begin to degrade for drawdowns that take over a year.
  3. Intermediate (50×150 to 50×250) and slow (75×225 to 75×375) trend models appear to do best for drawdowns in the 3-month to 1-year range.
  4. Very slow (100×300 to 200×400) trend models do very little at all for drawdowns over any timeframe.

Note that these results align with results found in earlier research commentaries about the relationship between measured convexity and trend speed.  Namely, faster trends appear to exhibit convexity when measured over shorter horizons, whereas slower trend speeds require longer measurement horizons.

But what happens if we change the drawdown profile from 20%?

Varying Drawdown Size

Calculations by Newfound Research.  Results are hypothetical.  Returns are gross of all fees, including manager fees, transaction costs, and taxes.

We can see some interesting patterns emerge.

First, for more shallow drawdowns, slower trend models struggle over almost all drawdown horizons.  On the one hand, a 10% drawdown occurring over a month will be too fast to capture.  On the other hand, a 10% drawdown occurring over several years will be swamped by the 35% volatility profile we simulated; there is too much noise and too little signal.

We can see that as the drawdowns become larger and the duration of the drawdown is extended, slower models begin to perform much better and faster models begin to degrade in relative performance.

Thus, if our goal is to protect against large losses over sustained periods (e.g. 20%+ over 6+ months), intermediate-to-slow trend models may be better suited our needs.

However, if we want to try to avoid more rapid, but shallow drawdowns (e.g. Q4 2018), faster trend models will likely have to be employed.

Varying Volatility

In our test, we specified that the drawdown periods would be simulated with an intrinsic volatility of 35%.  As we have explored briefly in the past, we expect that the optimal trend speed would be a function of both the dynamics of the trend process and the dynamics of the price process.  In simplified models (i.e. constant trend), we might assume the model speed is proportional to the trend speed relative to the price volatility.  For a more complex model, others have proposed that model speed should be proportional to the volatility of the trend process relative to the volatility of the price process.

Therefore, we also want to ask the question, “what happens if the volatility profile changes?”  Below, we re-create tables for a 20% and 40% drawdown, but now assume a 20% volatility level, about half of what was previously used.

Calculations by Newfound Research.  Results are hypothetical.  Returns are gross of all fees, including manager fees, transaction costs, and taxes.

We can see that results are improved almost without exception.1

Not only do faster models now perform better over longer drawdown horizons, but intermediate and slow models are now much more effective at horizons where they had previously not been.  For example, the classic 50×200 model saw an increase in its median return from -23.1% to -5.3% for 20% drawdowns occurring over 1.5 years.

It is worth acknowledging, however, that even with a reduced volatility profile, a shallower drawdown over a long horizon is still difficult for trend models to exploit.  We can see this in the last three rows of the 20% drawdown / 20% volatility table where none of the trend models exhibit a positive median return, despite having the ability to profit from shorting during a negative trend.


The transparent, “if-this-then-that” nature of trend following makes it well suited for scenario analysis.  However, the uncertainty of how price dynamics may evolve can make it difficult to say anything about the future with a high degree of precision.

In this commentary, we sought to evaluate the relationship between trend speed, drawdown size, drawdown speed, and asset volatility and a trend following systems ability to perform in drawdown scenarios.  We generally find that:

  • The effectiveness of trend speed appears to be positively correlated with drawdown speed. Intuitively, faster drawdowns require faster trend models.
  • Trend models struggle to capture shallow drawdowns (e.g. 10%). Faster trend models appear to be effective in capturing relatively shallow drawdowns (~20%), so long as they happen with sufficient speed (<6 months).  Slower models appear relatively ineffective against this class of drawdowns over all horizons, unless they occur with very little volatility.
  • Intermediate-to-slow trend models are most effective for larger, more prolonged drawdowns (e.g. 30%+ over 6+ months).
  • Lower intrinsic asset volatility appears to make trend models effective over longer drawdown horizons.

From peak-to-trough, the dot-com bubble imploded over about 2.5 years, with a drawdown of about -50% and a volatility of 24%.  The market meltdown in 2008, on the other hand, unraveled in 1.4 years, but had a -55% drawdown with 37% volatility.  Knowing this, we might expect a slower model to have performed better in early 2000, while an intermediate model might have performed best in 2008.

If only reality were that simple!

While our tests may have told us something about the expected performance, we only live through one realization.  The precise and idiosyncratic nature of how each drawdown unfolds will ultimately determine which trend models are successful and which are not.  Nevertheless, evaluating the historical periods of large U.S. equity drawdowns, we do see some common patterns emerge.

Calculations by Newfound Research.  Results are hypothetical.  Returns are gross of all fees, including manager fees, transaction costs, and taxes.

The sudden drawdown of 1987, for example, remains elusive for most of the models.  The dot-com and Great Recession were periods where intermediate-to-slow models did best.  But we can also see that trend is not a panacea: the 1946-1949 drawdown was very difficult for most trend models to navigate successfully.

Our conclusion is two-fold.  First, we should ensure that the trend model we select is in-line with the sorts of drawdown profiles we are looking to create convexity against.  Second, given the unknown nature of how drawdowns might evolve, it may be prudent to employ a variety of trend following models.


Taxes and Trend Equity

This post is available as a PDF download here.


  • Due to their highly active nature, trend following strategies are generally assumed to be tax inefficient.
  • Through the lens of a simple trend equity strategy, we explore this assertion to see what the actual profile of capital gains has looked like historically.
  • While a strategic allocation may only realize small capital gains at each rebalance, a trend equity strategy has a combination of large long-term capital gains interspersed with years that have either no gains or short-term capital losses.
  • Adding a little craftsmanship to the trend equity strategy can potentially improve the tax profile to make it less lumpy, thereby balancing the risk of having large unrealized gains with the risk of getting a large unwanted tax bill.
  • We believe that investors who expect to have higher tax rates in the future may benefit from strategies like trend equity that systematically lock in their gains more evenly through time.

Tax season for the year is quickly coming to a close, and while taxes are not a topic we cover frequently in these commentaries, it has a large impact on investor portfolios.

Source: xkcd

One of the primary reasons we do not cover it more is that it is investor-specific. Actionable insights are difficult to translate across investors without making broad assumptions about state and federal tax rates, security location (tax-exempt, tax deferred, or taxable), purchase time and holding period, losses or gains in other assets, health and family situation, etc.

Some sweeping generalizations can be made, such as that it is better to realize long-term capital gains than short-term ones, that having qualified dividends is better than having non-qualified ones, and that it is better to hold bonds in tax-deferred or tax-exempt accounts. But even these assertions are nuanced and depend on a variety of factors specific to an individual investor.

Trend equity strategies – and tactical strategies, in general – get a bad rap for being tax-inefficient. As assets are sold, capital gains are realized, often with no regard as to whether they are short-term or long-term. Wash sales are often ignored and holding periods may exclude dividends from qualifying status.

However, taxes represent yet another risk in a portfolio, and as you can likely guess if you are a frequent reader of these commentaries, reducing one risk is often done at the expense of increasing another.

The Risk in Taxes

Tax rates have been constant for long periods of time historically, especially in recent years, but they can change very rapidly depending on the overall economic environment.

Source: IRS, U.S. Census Bureau, and Tax Foundation. Calculations by Newfound Research. Series are limited by historical data availability.

The history shows a wide array of scenarios.

Prior to the 1980s, marginal tax rates spanned an extremely wide band, with the lowest tier near 0% and the top rate approaching 95%. However, this range has been much narrower for the past 30 years.

In the late 1980s when tax policy became much less progressive, investors could fall into only two tax brackets.

While the income quantile data history is limited, even prior to the narrowing of the marginal tax range, the bulk of individuals had marginal tax rates under 30%.

Turning to long-term capital gains rates, which apply to asset held for more than a year, we see similar changes over time.

Source: U.S. Department of the Treasury, Office of Tax Analysis and Tax Foundation.

For all earners, these rates are less than their marginal rates, which is currently the tax rate applied to short-term capital gains. While there were times in the 1970s when these long-term rates topped out at 40%, the maximum rate has dipped down as low as 15%. And since the Financial Crisis in 2008, taxpayers in the lower tax brackets pay 0% on long-term capital gains.

It is these large potential shifts in tax rates that introduce risk into the tax-aware investment planning process.

To see this more concretely, consider a hypothetical investment that earns 7% every year. Somehow – how is not relevant for this example – you have the choice of having the gains distributed annually as long-term capital gains or deferred until the sale of the asset.

Which option should you choose?

The natural choice is to have the taxes deferred until the sale of the asset. For a 10-year holding period where long-term capital gains are taxed at 20%, the pre-tax and after-tax values of a $1,000 investment are shown below.

The price return only version had a substantially higher pre-tax value as the full 7% was allowed to compound from year to year without the hinderance of an annual tax hit.

At the end of the 10-year period, the tax basis of the approach that distributed gains annually had increased up to the pre-tax amount, so it owed no additional taxes once the asset was sold. However, the approach that deferred taxes still ended up better after factoring in the tax on the embedded long-term capital gains that were realized upon the sale.

Now let’s consider the same assets but this time invested from 2004 to 2014 when the maximum long-term capital gains rate jumped to 25% in 2013 after being around 15% for the first 8 years.

The pre-tax picture is still the same: the deferred approach easily beat the asset that distributed capital gains annually.

But the after-tax values have changed order. Locking in more of the return when long-term capital gains tax rates were lower was advantageous.

The difference in this case may not be that significant. But consider a more extreme – yet still realistic – example where your tax rate on the gains jumps by more than ten percentage points (e.g. due to a change in employment or family situation or tax law changes), and the decision over which type of asset you prefer is not as clear cut.

Moving beyond this simple thought experiment, we now turn to the tax impacts on trend equity strategies.

Tax Impacts in Trend Equity

We will begin with a simple trend equity strategy that buys the U.S. stock market (the ETF VTI) when it has a positive 9-month return and buys short-term U.S. Treasuries (the ETF SHV) otherwise. Prior to ETF inception, we will rely on data from the Kenneth French Data Library to extend the analysis back to the 1920s. We will evaluate the strategy monthly and, for simplicity, will treat dividends as price returns.

With taxes now in the mix, we must track the individual tax lots as the strategy trades over time based on the tactical model. For deciding which tax lots to sell, we will select the ones with the lowest tax cost, making the assumption that short-term capital gains are taxed 50% higher than long-term capital gains (approximately true for investors with tax rates of 22% and 15%, respectively, in the current tax code).

We must address the question of when an investor purchases the trend equity strategy as a long bull market with a consistent positive trend would have very different tax costs for an investor holding all the way through versus one who bought at end.

To keep the analysis as simple as possible given the already difficult specification, we will look at an investment that is made at the very beginning, assume that taxes are paid at the end of each year, and compare the average annualized pre-tax and after-tax returns. Fortunately, for this type of trend strategy that can move entirely in and out of assets, the tax memory will occasionally reset.

To set some context, first, we need a benchmark.

Obviously, if you purchased VTI and held it for the entire time, you would be sitting on some large embedded capital gains.1

Instead, we will use a more appropriate benchmark for trend equity: a 50%/50% blend of VTI and SHV. We will rebalance this blend annually, which will lead to some capital gains.

The following chart shows the capital gains aggregated by year as a percentage of the end of the year account value.

Source: CSI Data and Kenneth French Data Library. Calculations by Newfound.

As expected with the annual rebalancing, all of the capital gains are long-term. Any short-term gains are an artifact of the rigidity of the rebalancing system where the first business day of subsequent years might be fewer than 365 days apart. In reality, you would likely incorporate some flexibility in the rebalances to ensure all long-term capital gains.

While this strategy incurs some capital gains, they are modest, with none surpassing 10%. Paying taxes on these gains is a small price to pay for maintaining a target allocation, supposing that is the primary goal.

Assuming tax rates of 15% for long-term gains and 25% for short-term gains, the annualized returns of the strategic allocation pre-tax and after-tax are shown below. The difference is minor.

Source: CSI Data and Kenneth French Data Library. Calculations by Newfound.

Now on to the trend equity strategy.

The historical capital gains look very different than those of the strategic portfolio.

Source: CSI Data and Kenneth French Data Library. Calculations by Newfound.

In certain years, the strategy locks in long-term capital gains greater than 50%. The time between these years is interspersed with larger short-term capital losses from whipsaws or year with essentially no realized gains or losses, either short- or long-term.

In fact, 31 of the 91 years had absolute realized gains/losses of less than 1% for both short- and long-term.

Now the difference between pre-tax and after-tax returns is 100 bps per year using the assumed tax rates (15% and 25%). This is significantly higher than with the strategic allocation.

Source: CSI Data and Kenneth French Data Library. Calculations by Newfound.

It would appear that trend equity is far less tax efficient than the strategic benchmark. As with all things taxes, however, there are nuances. As we mentioned in the first section of this commentary, tax rates can change at any time, either from a federal mandate or a change in an individual’s situation. If you are stuck with a considerable unrealized capital gain, it may be too late to adjust the course.

Source: CSI Data and Kenneth French Data Library. Calculations by Newfound.

The median unrealized capital gain for the trend equity strategy is 10%. This, of course, means that you must realize the gains periodically and therefore pay taxes.

But if you are sitting with a 400% unrealized gain in a different strategy, behaviorally, it may be difficult to make a prudent investment decision knowing that a large tax bill will soon follow a sale. And a 10 percentage point increase in the capital gains tax rate can have a much larger impact in dollar terms on the large unrealized gain than missing out on some compounding when rates were lower.

Even so, the thought of paying taxes intermediately and missing out on compound growth can still be irksome. Some small improvement to the trend equity strategy design can prove beneficial.

Improving the Tax Profile Within Trend Equity

This commentary would be incomplete without a further exploration down some of the axes of diversification.

We can take the simple 9-month trend following strategy and diversify it along the “how” axis using a multi-model approach with multiple lookback periods.

Specifically, we will use price versus moving average and moving average cross-overs in addition to the trailing return signal and look at windows of data ranging from 6 to 12 months.2

We can also diversify along the “when” axis by tranching the monthly strategy over 20 days. This has the effect of removing the luck – either good or bad – of rebalancing on a certain day of the month.

Below, we plot the characteristics of the long-term capital gains for the strategies in years in which a long-term gain was realized.

Source: CSI Data and Kenneth French Data Library. Calculations by Newfound.

The single monthly model had about a third of the years with long-term gains. Tranching it took that fraction to over a half. Moving to a multi-model approach brought the fraction to 60%, and tranching that upped it to 2 out of every 3 years.

Source: CSI Data and Kenneth French Data Library. Calculations by Newfound.

From an annualized return perspective, all of these trend equity strategies exhibited similar return differentials between pre-tax and after-tax.

In previous commentaries, we have illustrated how tranching to remove timing luck and utilizing multiple trend following models can remove the potential dispersion in realized terminal wealth. However, in the case of taxes, these embellishments did not yield a reduction in the tax gap.

While these improvements to trend equity strategies reduce specification-based whipsaw, they often result in similar allocations for large periods of time, especially since these strategies only utilize a single asset.

But to assume that simplicity trumps complexity just because the return differentials are not improved misses the point.3

With similar returns among within the trend-following strategies, using an approach that realizes more long-term capital gains could still be beneficial from a tax perspective.

In essence, this can be thought of as akin to dollar-cost averaging.

Dollar-cost averaging to invest a lump sum of capital is often not optimal if the sole goal is to generate the highest return.4 However, it is often beneficial in that it reduces the risk of bad outcomes (i.e. tail events).

Having a strategy – like trend equity – that has the potential to generate strong returns while taking some of those returns as long-term capital gains can be a good hedge against rising tax rates. And having a diversified trend equity strategy that can realize these capital gains in a smoother fashion is icing on the cake.


Taxes are a tricky subject, especially from the asset manager’s perspective. How do you design a strategy that suits all tax needs of its investors?

Rather than trying to develop a one-size-fits-all strategy, we believe that a better approach to the tax question is education. By more thoroughly understanding the tax profile of a strategy, investors can more comfortably deploy it appropriately in their portfolios.

As highly active strategies, trend equity mandates are generally assumed to be highly tax-inefficient. We believe it is more meaningful to represent the tax characteristics an exchange of risks: capital gains are locked in at the current tax rates (most often long-term) while unrealized capital gains are kept below a reasonable level. These strategies have also historically exhibited occasional periods with short-term capital losses.

These strategies can benefit investors who expect to have higher tax rates in the future without the option of having a way to mitigate this risk otherwise (e.g. a large tax-deferred account like a cash balance plan, donations to charity, a step-up in cost basis, etc.).

Of course, the question about the interplay between tax rates and asset returns, which was ignored in this analysis, remains. But in an uncertain future, the best course of investment action is often the one that diversifies away as much uncompensated risk as possible and includes a comprehensive plan for risk management.

The Monsters of Investing: Fast and Slow Failure

This post is available as a PDF download here.


  • Successful investing requires that investors navigate around a large number of risks throughout their lifecycle. We believe that the two most daunting risks investors face are the risk of failing fast and the risk of failing slow.
  • Slow failure occurs when an investor does not grow their investment capital sufficiently over time to meet future real liabilities. This often occurs because they fail to save enough or because they invest too conservatively.
  • Fast failure occurs when an investor – often those who are living off of portfolio withdrawals and for whom time is no longer an ally – suffers a significant drawdown that permanently impairs their portfolio.
  • We believe that sensitivity to these risks should dictate an investor’s allocation profile. Investors sensitive to slow failure should invest more aggressively and bear more risk in certain bad states of the world for the potential to earn excess returns in good states.  On the other hand, investors sensitive to fast failure should invest more conservatively, sacrificing returns in order to avoid catastrophe.
  • We believe this framework can also be used to inform how investors can fund an allocation from their strategic policy to trend equity strategies.

Homer’s Odyssey follows the epic ten-year journey of Odysseus and his men as they try to make their way home after the fall of Troy.  Along the way, the soldiers faced a seemingly endless string of challenges, including a cyclops who ate them alive, a sorceress who turned them into pigs, and sirens that would have lured them to their deaths with a song had they not plugged their ears with beeswax.

In one trial, the men had to navigate the Strait of Messina between the sea monsters Scylla and Charybdis.  With her six serpentine heads, each with a triple row of sharp teeth, Scylla haunted the cliffs that lined one edge of the strait.  Ships that came too close would immediately lose six sailors to the ravenous monster.  Living under a rock on the other side of the strait was Charybdis.  A few times a day, this monster would swallow up large amounts of water and belch it out, creating whirlpools that could sink an entire ship.

The strait was so narrow that the monsters lived within an arrow’s range of one another. To safely avoid one creature meant almost necessarily venturing too close to the other.  On the one hand was almost certain, but limited, loss; on the other, the low probability of complete catastrophe.

Investors, similarly, must navigate between two risks: what we have called in the past the risks of failing slow and failing fast.

Slow failure results from taking too little risk, often from investors allocating too conservatively or holding excessive cash.  In doing so, they fail to grow their capital at a sufficient rate to meet future real liabilities.  Failure in this arena does not show up as a large portfolio drawdown: it creeps into the portfolio over time through opportunity cost or the slow erosion of purchasing power.

Fast failure results from the opposite scenario: taking too much risk.  By allocating too aggressively (either to highly skewed or highly volatile investments), investors might incur material losses in their portfolios at a time when they cannot afford to do so.

We would argue that much of portfolio design is centered around figuring out which risk an investor is most sensitive to at a given point in their lifecycle and adjusting the portfolio accordingly.

Younger investors, for example, often have significant human capital (i.e. future earning potential) but very little investment capital.  Sudden and large losses in their portfolios, therefore, are often immaterial in the long run, as both time and savings are on their side. Investing too conservatively at this stage in life can rely too heavily on savings and fail to exploit the compounding potential of time.

Therefore, younger, growth-oriented investors should be willing to bear the risk of failing fast to avoid the risk of failing slow.  In fact, we would argue that it is the willingness to bear the risk of failing fast that allows these investors to potentially earn a premium in the first place.  No pain, no premium.

Over time, investors turn their human capital into investment capital through savings and investment.  At retirement, investors believe that their future liabilities are sufficiently funded, and so give-up gainful employment to live off of their savings and investments. In other words, the sensitivity to slow failure has significantly declined.

However, with less time for the potential benefits of compounding and no plan on replenishing investments through further savings, the sensitivity to the risk of fast failure is dramatically heightened, especially in the years just prior to and just after retirement.  This is further complicated by the fact that withdrawals from the portfolio can heighten the impact of sustained and large drawdowns.

Thus, older investors tend shift from riskier stocks to safer bonds, offloading their fast failure risk to those willing to bear it.  Yet we should be hesitant to de-risk entirely; we must also acknowledge longevity risk.  Too conservative a profile may also lead to disaster if an investor outlives their nest-egg.

As we balance the scales of failing fast and slow, we can see why trying to invest a perpetual endowment is so difficult.  Consistent withdrawals invite the risk of failing fast while the perpetual nature invites the risk of failing slow.  A narrow strait to navigate between Scylla and Charybdis, indeed!

We would be remiss if we did not acknowledge that short-term, high quality bonds are not a panacea for fail fast risk.  Inflation complicates the calculus and unexpected bouts of inflation (e.g. the U.S. in the 1970s) or hyper-inflation (e.g. Brazil in the 1980s, Peru from 1988-1991, or present-day Venezuela) can cause significant, if not catastrophic, declines in real purchasing power if enough investment risk is not borne.

Purchasing seemingly more volatile assets may actually be a hedge here.  For example, real estate, when marked-to-market, may exhibit significant relative swings in value over time.  However, as housing frequently represents one the largest real liabilities an investor faces, purchase of a primary residence can lock in the real cost of the asset and provide significant physical utility. Investors can further reduce inflation risk by financing the purchase with a modest amount of debt, a liability which will decline in real value with unexpected positive inflation shocks.

The aforementioned nuances notwithstanding, this broad line of thinking invites some interesting guidance regarding portfolio construction.

Investors sensitive to fast failure should seek to immunize their real future liabilities (e.g. via insurance, real asset purchases, cash-flow matching, structured products, et cetera).  As they survey the infinite potential of future market states, they should be willing to give up returns in all states to avoid significant failure in any given one of them.

Investors sensitive to slow failure should seek to bear a diversified set of risk premia (e.g. equity risk premium, bond risk premium, credit premium, value, momentum, carry, et cetera) that allows their portfolios to grow sufficiently to meet future real liabilities.  These investors, then, are willing to pursue higher returns in the vast majority of future market states, even if it means increased losses in a few states.

I personally imagine this as if the investor sensitive to failing slow has piled up all their risk – like a big mound of dough – in the bad outcome states of the world. For their willingness to bear this risk, they earn more return in the good outcome states.  The investor sensitive to failing fast, on the other hand, smears that mound of risk across all the potential outcomes.  In their unwillingness to bear risk in a particular state, they reduce return potential across all states, but also avoid the risk of catastrophe.

Source: BuzzFeed


Quantitatively, we saw exactly this trade-off play out in our piece The New Glide Path, where we attempted to identify the appropriate asset allocation for investors in retirement based upon their wealth level. We found that:

  • Investors who were dramatically under-funded – i.e. those at risk of failing slow – relative to real liabilities were allocated heavily to equities.
  • Investors who were near a safe funding level – i.e. those at risk of failing fast – were tilted dramatically towards assets like Treasury bonds in order to immunize their portfolio against fast failure.
  • The fortunate few investors who were dramatically over-funded could, pretty much, allocate however they pleased.

We believe this same failing slow and failing fast framework can also inform how trend equity strategies – like those we manage here at Newfound Research – can be implemented by allocators.

In our recent commentary Three Applications of Trend Equity we explored three implementation ideas for trend equity strategies: (1) as a defensive equity sleeve; (2) as a tactical pivot; or (3) as an alternative.  While these are the most common approaches we see to implementing trend equity, we would argue that a more philosophically consistent route might be one that incorporates the notions of failing fast and failing slow.

In Risk Ignition with Trend Following we examined the realized efficient frontier of U.S. stocks and bonds from 1962-2017 and found that an investor who wanted to hold a portfolio targeting an annualized volatility of 10% would need to hold between 40-50% of their portfolio in bonds.  If we were able to magically eliminate the three worst years of equity returns, at the cost of giving up the three best, that number dropped to 20-30%.  And if we were able to eliminate the worst five at the cost of giving up the best five? Just 10%.

One interpretation of this data is that, with the benefit of hindsight, a moderate-risk investor would have had to carry a hefty allocation to bonds for the 55 years just to hedge against the low-probability risk of failing fast.  If we believe the historical evidence supporting trend equity strategies, however, we may have an interesting solution at hand:

  • A strategy that has historically captured a significant proportion of the equity risk premium.
  • A strategy that has historically avoided a significant proportion of prolonged equity market declines.

Used appropriately, this strategy may help investors who are sensitive to failing slowly tactically increase their equity exposure when trends are favorable. Conversely, trend equity may help investors who are sensitive to failing fast de-risk their portfolio during negative trend environments.

To explore this opportunity, we will look at three strategic profiles: an 80% U.S. equity / 20% U.S. bond mix, a 50/50 mix, and a 20/80 mix.  The first portfolio represents the profile of a growth investor who is sensitive to failing slow; the second portfolio represents a balanced investor, sensitive to both risks; the third represents a conservative investor who is sensitive to failing fast.

We will allocate a 10% slice of each portfolio to a naïve trend equity strategy in reverse proportion to the stock/bond mix.  For example, for the 80/20 portfolio, 2% of the equity position and 8% of the bond position will be used to fund the trend equity position, creating a 78/12/10 portfolio.  Similarly, the 20/80 will become an 12/78/10 and the 50/50 will become a 45/45/10.

We will use the S&P 500 index for U.S. equities, Dow Jones Corporate Bond index for U.S. bonds, and a 1-Year U.S. Government Note index for our cash proxy. The trend equity strategy will blend signals generated from trailing 6-through-12-month total returns, investing in the S&P 500 over the subsequent month in proportion to the number of positive signals.  Remaining capital will be invested in the cash proxy.  All portfolios are rebalanced monthly from 12/31/1940 through 12/31/2018.

Below we report the annualized returns, volatility, maximum drawdown, and Ulcer index (which seeks to simultaneously measure the duration and depth of drawdowns and can serve as a measure to a portfolio’s sensitivity to failing fast) for each profile.

Fail Fast


Fail Slow




Annualized Return




Annualized Volatility




Maximum Drawdown




Ulcer Index




Source: Global Financial Data.  Calculations by Newfound Research.  Returns are backtested and hypothetical. Past performance is not a guarantee of future results.  Returns are gross of all fees.  Returns assume the reinvestment of all distributions.  None of the strategies shown reflect any portfolio managed by Newfound Research and were constructed solely for demonstration purposes within this commentary.  You cannot invest in an index. 


For conservative investors sensitive to the risk of failing fast, we can see that the introduction of trend equity not only slightly increased returns, but it reduced the maximum drawdown and Ulcer index profile of the portfolio.  Below we plot the actual difference in portfolio drawdowns between a 12/78/10 mix and a 20/80 mix over the backtested period.

While we can see that there are periods where the 12/78/10 mix exhibited higher drawdowns (i.e. values below the 0% line), during major drawdown periods, the 12/78/10 mix historically provided relative relief.  This is in line with our philosophy that risk cannot be destroyed, only transformed: the historical benefits that trend following has exhibited to avoiding significant and prolonged drawdowns have often come at the cost of increased realized drawdowns due to a slightly increased average allocation to equities as well as self-incurred drawdowns due to trading whipsaws.

On the opposite end of the spectrum, we can see that those investors sensitive to failing slowly were able to increase annualized returns without a significant increase to maximum drawdown.  We should note, however, an increase in the Ulcer index, indicating more frequent and deeper drawdowns.

This makes sense, as we would expect the 78/12/10 mix to be on average over-allocated to equities, making it more sensitive to quick and sudden declines (e.g. 1987).  Furthermore, the most defensive the mix can tilt is towards a 78/22 blend, leaving little wiggle-room in its ability to mitigate downside exposure. Nevertheless, we can see below that during periods of more prolonged drawdowns (e.g. 1975, 1980, and 2008), the 78/12/10 mix was able to reduce the drawdown profile slightly.

In these backtests we see that investors sensitive to failing fast can fund a larger proportion of trend equity exposure from their traditional equity allocation in an effort to reduce risk while maintaining their return profile. Conversely, investors sensitive to failing slow can fund a larger proportion of their trend equity exposure from bonds, hoping to increase their annualized return while maintaining the same risk exposure.

Of course, long-term annualized return statistics can belie short-term experience. Examining rolling return periods, we can gain a better sense as to our confidence as to the time horizon over which we might expect, with confidence, that a strategy should contribute to our portfolio.

Below we plot rolling 1-to-10-year annualized return differences between the 78/12/10 and the 80/20 mixes.

We can see that in the short-term (e.g. 1-year), there are periods of both significant out- and under-performance.  Over longer periods (5- and 10-years), which tend to capture “full market cycles,” we see more consistent out-performance.

Of course, this is not always the case: the 78/12/10 mix underperformed the 80/20 portfolio for the 10 years following the October 1987 market crash.  Being over-allocated to equities at that time had a rippling effect and serves to remind us that our default assumption should be that “risk cannot be destroyed, only transformed.”  But when we have the option to adjust our exposure to these risks, the benefit of avoiding slow failure may outweigh the potential to underperform slightly.

This evidence suggests that funding an allocation to trend equity in a manner that is in line with an investor’s risk sensitivities may be beneficial. Nevertheless, we should also acknowledge that the potential benefits are rarely realized in a smooth, continuous manner and that the implementation should be considered a long-term allocation, not a trade.


Investors must navigate a significant number of risks throughout their lifecycle.  At Newfound, we like to think of the two driving risks that investors face as the risk of failing fast and the risk of failing slow.  Much like Odysseus navigating between Scylla and Charybdis, these risks are at direct odds with one another and trying to avoid one increases the risk of the other.

Fortunately, which of these risks an investor cares about evolves throughout their lifecycle.  Young investors typically can afford to fail fast, as they have both future earning potential and time on their side.  By not saving adequately, or investing too conservatively, however, a young investor can invite the risk of slow failure and find themselves woefully underfunded for future real liabilities.  Hence investors at this stage or typically aggressively allocated towards growth assets.

As investors age, time and earning potential dwindle and the risk of fast failure increases. At this point, large and prolonged drawdowns can permanently impair an investor’s lifestyle.  So long as real liabilities are sufficiently funded, the risk of slow failure dwindles.  Thus, investors often de-risk their portfolios towards stable return sources such as high-quality fixed income.

We believe this dual-risk framework is a useful model for determining how any asset or strategy should fit within a particular investor’s plan.  We demonstrate this concept with a simple trend equity strategy.  For an investor sensitive to slow failure, we fund the allocation predominately from bond exposure; for an investor sensitive to fast failure, we fund the allocation predominately form equities.

Ultimately – and consistent with findings in our other commentaries – a risk-based mindset makes it obvious that allocation choices are really all about trade-offs in opportunity (“no pain, no premium”) and risk (“risk cannot be destroyed, only transformed.”)

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