Wednesday, January 31, 2018

The Behavioral and Performance Benefits of Trend Following

When we tell our investors to invest for the long run, we have to make sure the short run doesn’t kill them first… Investing for the long run isn’t bad advice, it’s just unrealistic. It doesn’t take into account human behavior.

-Andrew Lo (HT: Andrew Thrasher)

Trend following has historically provided strong long-term returns with materially reduced drawdowns relative to a traditional buy and hold investment, but none of this matters if an investor cannot stick with the strategy through periods of relative underperformance. This “opportunity cost” is often felt the most during periods when more traditional allocations outperform.

The consistency of a trend following strategy’s relative performance vs a 60/40 portfolio (impacting the ability for investors to stick with trend following) is the basis of an argument that’s taken place offline (yes, I also argue offline) with a FinTwit friend who is a huge proponent of buy and hold. It’s progressed to the point that we’ve discussed making a mini (very mini) Buffett style bet related to whether trend following or a 60% US Stock / 40% Bond allocation will outperform over the next five years (with money going to the winner's charity of choice).

Given we've hit a dead-end due to his view that the result will be a coin flip (i.e. random whether trend or buy and hold outperforms, thus even if he were to lose it would be random as well), I thought I would put my case forward in this post outlining why I think trend following has a much higher probability of outperforming a 60/40 portfolio in most environments and especially in the current environment.

Backdrop: What is Trend?

As outlined in a previous post:

In a nutshell, trend following is simply a means of determining if you will own an asset based on its recent price history. 
One simple set of trend following rules are: ­
  • If the S&P 500 Total Return Index > 12-Month Moving Average, Own Stocks ­ 
  • Otherwise Own Bonds
The diagrams below depict how those without an understanding of trend following often believe it works vs how it really works. The original image on the left is used with permission from Carl Richards and outlines how poorly behaved investors often act, while my revised version on the right outlines what trend followers attempt to do (follow Carl on Twitter @behaviorgap).

Buy and hold investors seem to perceive trend followers in a similar light as these poorly behaved investors, chasing strong returns higher and selling out once markets have completely rolled over. In practice, trend following buys / sells after major turning points, thus gets back into markets once a new trend forms and holds until there is another turning point... often much later than when the investor would have otherwise preferred to sell. The opportunity cost of trend following is the willingness to miss initial turns and to be wrong over many intermediate periods until a new long-term trend emerges.

How Often Does Trend Following Outperform?

As the chart below shows, trend-following outperformance has occurred at a much higher rate than a coin flip and that beat rate has increased over longer periods. This specific 12-month trend model outperformed a 60/40 portfolio over ~80% of rolling 60-month time frames since 1926 and 90%+ of the time over 10 and 15 year periods. 

To get a better sense of when these periods of outperformance and underperformance occurred, the following chart breaks out when trend following outperformed a 60/40 portfolio (blue) and when it did not (white) over rolling 60-month time frames. 

A few things to note:
  1. the trend following model outperformed a 60/40 portfolio consistently
  2. the trend following model outperformed over extended periods of time
  3. periods of trend following underperformance were short lived and clustered
  4. periods of relative underperformance were more likely to occur when the opportunity cost associated with moving away from a 60/40 portfolio were high
Specific to point #4, the chart below shows the historical yield of a 60/40 portfolio (i.e. what can be viewed as the likely opportunity cost of trend following). We can see that a high starting yield that compressed quickly in the mid 1930's coincided with the underperformance that took place in the late 1930's / early 1940's, while the huge yield compression of a 60/40 portfolio in the mid 1980's coincided with the challenging relative performance in the late 1980's / early 1990's.

Current Expectation

Simply put, the starting yield / opportunity cost of a 60/40 portfolio is extremely low at ~3%. Historically, when we split the universe into buckets when the starting 60/40 yield was above or below the long-term 6% average (3% higher than the current level), we can see the increased likelihood a trend following strategy outperforms at lower starting yields. In fact, the historical beat rate over rolling 5 year time frames moves up to 85%.


I really like the way my friend Wes from Alpha Architect framed this decision:
Flip it and make trend following the benchmark and consider buy and hold. Works sometimes, doesn't work other times, but you eat massive tail risk with buy and hold, therefore isn't worth the risk/effort.
In other words, if trend following is your base allocation, would you as an investor allocate to a different strategy that underperformed at a 70%+ rate over 3-5 year rolling time frames and 90-100% of rolling 10-15 year time frames, and had materially more downside risk? Not only would I not make that allocation, I'd love to bet someone with proceeds going to charity that trend following would outperform.

Appendix: Tax Efficiency of Trend Following

A common question that comes up related to trend following is its tax efficiency. The reason I ended up ignoring the tax issue as a detriment to trend following in the analysis is that trend following may actually be more tax efficient than a buy and hold allocation that includes taxable bonds.

A few reasons:
  1. A trend following solution can be structured utilizing futures, which are taxed at 60% the long-term rate and 40% the short-term rate, making it pretty similar to a 60/40 portfolio
  2. Even with cash holdings, trend following can be tax efficient as the large gains in stocks are often held much longer than 12 months (i.e. are taxed at the long-term rate). The chart below shows the length of each past isolated trend, along with the gains earned in these trends showing that significant gains were often taken years after the initial trend signal.

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