History of Trend & Momentum
Introduction to Trend Equity
- A particularly interesting feature about trend following is its potential ability to avoid significant losses. Evidence suggests that trend following approaches can be used as alternative risk management techniques.
- 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.
- For long/flat trend equity strategies, we introduce two potential decompositions.
- The first implementation is similar to equity exposure with a put option overlay. The second is similar to a 50% equity / 50% cash allocation with a 50% overlay to a straddle.
- A 50/50 portfolio of equities and cash is generally an appropriate benchmark for long/flat trend-following strategies, both for setting expectations and for gauging current relative performance.
- In the case of tactical equity strategies, periods of large absolute changes in the equity market and positive interest rate changes have historically created favorable performance versus a balanced stock/bond allocation. These factors can give context for setting expectations.
Using Trend Equity
- Historically, bonds have acted as the primary means of managing risk. However, historical evidence suggests that investors may carry around a significant allocation to fixed income only to offset the tail risks of a few bad years in equities.
- Traditionally, stock/bond glide paths have been used to control sequence risk. However, trend-following may be able to serve as a valuable hybrid between equities and bonds and provide a means to diversify our diversifiers.
- We find that trend-following receives a significant allocation – largely in lieu of equity exposure – for investors early in retirement and whose initial consumption rate closely reflects the 4% level.
- While we believe that trend following is most appropriate for investors concerned about sequence risk, levered trend following may have use for investors pursuing growth.
- In a simple back-test, a naïve levered trend following considerably increases annualized returns and reduces negative skew and kurtosis (“fat tails”).
Building Robust Strategies
- We demonstrate how using only a single signal to drive portfolio allocations can make a portfolio highly sensitive to the impact of randomness, clouding our ability to determine the difference between skill and luck.
- We demonstrate that the year-to-year performance difference can span hundreds, if not thousands, of basis points between the implementations, highlighting what we call specification risk.
- By simply diversifying across multiple implementations, we can dramatically reduce model specification risk and even potentially see improvements in realized metrics such as Sharpe ratio and maximum drawdown.
- We believe the increased internal diversification allows not only for a higher probability of success, but also increases the degrees of freedom with which we can manage the strategy.
- We explore how investors can think about introducing greater diversification across the three axes of what, how, and when in effort to build a more robust tactical solution.
- In this commentary, we attempt to measure how much diversification opportunity is available by employing multiple models with multiple parameterizations in a simple long/flat trend-following process.
- Long/flat trend-following strategies have historically delivered payout profiles similar to those of call options, with positive payouts for larger positive underlying asset returns and slightly negative payouts for near-zero or negative underlying returns.
- Taking a multi-model approach to trend-following can be used to reduce the variance around the expected payout profile.
- Empirical evidence suggests that in heterogeneous categories (e.g. many hedge fund styles), combining managers can reduce portfolio volatility. Yet even in homogenous categories (e.g. equity style boxes), combining managers can have a pronounced effect on reducing the dispersion in terminal wealth.
- Trend following is unique among style premia in that it has historically exhibited a convex payoff profile with positive skew. While the historical premium is anomalous, the convexity makes sense when we use options to replicate trend following strategies.
- We demonstrate that the convexity exhibited by trend equity strategies is both a function of the strategy itself (i.e. a fast- or slow-paced trend model) as well as the horizon we measure returns over.