The Ins and Outs of Trend Following

The Ins and Outs of Trend Following

Trend following is a popular investment strategy that has gained significant attention in recent years, particularly in the realm of equity investing. This article will delve into the concept of trend following, its effectiveness, the metrics and lookback periods commonly employed, and the behavioral challenges it presents to investors.

What is Trend Following?

Trend following is an investment approach that involves taking positions in positively trending assets. The basic premise is to buy assets that are showing an upward trend and sell or short those that are displaying a downward trend. This strategy is based on the belief that markets tend to move in trends, and by identifying and following these trends, investors can potentially generate profits.

In his paper, “A Quantitative Approach to Tactical Asset Allocation,” Meb Faber showed that trend following not only works, but can also be very simple to implement. Faber’s research demonstrated that a simple trend-following system, using a 10-month moving average to exit equities when they were in a downtrend, could outperform the market over the long term with lower drawdowns.

Why Trend Following Works

Trend following works because it capitalizes on the tendency of markets to exhibit momentum. Assets that have been performing well tend to continue performing well, while those that have been underperforming tend to continue underperforming. By aligning investments with these trends, investors can potentially capture gains and minimize losses.

Moreover, trend following provides a systematic approach to investing, removing the emotional biases that often cloud judgment.

Metrics and Lookback Periods

Trend followers typically employ various metrics and lookback periods to identify trends and generate trading signals. One of the most commonly used metrics is the moving average, which smooths out price fluctuations and provides a clearer picture of the underlying trend. The lookback period, or the time frame over which the moving average is calculated, can vary depending on the investor’s preferences and the characteristics of the asset being traded.

Faber’s original paper suggested using a 10-month moving average as a simple and effective trend-following rule. When the current price is above the 10-month moving average, the asset is considered to be in an uptrend, and a long position is taken. Conversely, when the price falls below the moving average, the asset is deemed to be in a downtrend, and the position is sold.

In the real world practitioners typically use a combination of lookback periods when constructing a trend following strategy. This can smooth our returns over time and eliminate the risk that the individual metric selected proves to be the wrong one in any given decline.

Return Profile and Comparison to Buy and Hold

One of the key benefits of trend following is its potential to minimize losses relative to a traditional buy-and-hold strategy. By actively managing positions based on prevailing trends, trend followers aim to capture gains during bull markets while minimizing losses during bear markets.

Research by Alpha Architect has shown that trend following can provide superior risk-adjusted returns compared to a passive buy-and-hold approach. In their study, they found that a simple trend-following strategy applied to the S&P 500 index outperformed the benchmark on a risk-adjusted basis over a 90-year period (Alpha Architect, 2019).

However, it is essential to note that trend following often results in a return profile that deviates from the overall market. During strong bull markets, trend-following strategies may underperform as they may miss out on some of the gains. Conversely, during bear markets, trend followers may outperform by avoiding significant drawdowns.

Trend Following Performance

At Validea, we use a multi-moving average system for our trend following tool. We have tested it back to 1971 and the results are below. As you can see from the chart, our system has produced similar results to those Meb Faber showed in his paper, with a return of around 1% greater than the S&P 500, but a significantly smaller maximum drawdown.

Behavioral Challenges and Signal Accuracy

One of the primary challenges of implementing a trend-following strategy is the behavioral aspect. Trend following often requires investors to deviate from popular benchmarks and to be out of the market when other investors are not. This can make the strategy very challenging to stick with. Trend following strategies are also typically wrong more than they are right. The reason the strategy works is that these small incorrect signals are typically offset by major correct signals like the one most trend following systems issued prior to the 2008 bear market. But the high volume of incorrect signals can be very challenging for investors, as has been evidenced in the period since 2008.

The Pros and Cons of Trend

Trend following is a powerful investment strategy that has the potential to generate superior risk-adjusted returns to a buy and hold approach.

However, implementing a trend-following strategy requires a systematic approach, a clear understanding of the metrics and lookback periods involved, and the ability to manage the behavioral challenges that arise from deviating from the market consensus.

As with any investment strategy, trend following is not without risks, and investors must be prepared for periods of underperformance. Nonetheless, for those willing to embrace a disciplined, rules-based approach, trend following can be a valuable addition to their investment toolkit.

Further Research

Validea’s Trend Following System

S&P 500 Trend Following