There are many trading legends of lore around the concept of “ Trend Following Strategy .” Perhaps the passive “The trend is your friend” is best known, but also the mantras “Don’t fight the trend,” “Cut losses short and let profits run” and “Trends have always come and gone throughout history” are most meaningful. Now a new study from AQR Capital Management’s Brian Hurst, Yao Hua Ooi and Lasse Heje Pederson, who shares time at New York University, have put meat on some of the legends. In what is arguably the most robust date range study of trend following the performance to date using futures price data – AQR researchers combed through Chicago Board of Trade annual reports back to 1877 – a clear message emerges: price trends have always been a fact of markets.
A study of market trends using 100 years of futures price data
What matters to AQR’s statistically focused researchers is not so much why market price trends exist. Their mission in the paper “A Century of Evidence of Trend-Following Investing” was not so much a discretionary attempt to explain the economic rationale as to why a market price moves in one direction and continues to persist over time. What they wanted to accomplish was to document the fact that market price trends are and have always been a fact of markets.
To prove the thesis that price trends are a fact of markets, researchers Hurst, Ooi and Heje combine time series momentum study with a moving average cross to determine the profitability of a trend following strategy for over a century. The study essentially followed “the most basic trend-following strategy,” which conceptually involves “going long markets with recent positive returns and shorting those with recent negative returns.”
While other studies have used futures spot prices to study date ranges over a century, this is the first study using futures data – the actual product CTA trend followers trade – to make the point that trend following held up during a wide variety of historical market environments – including crisis.
Trend Following Strategy works best in low correlation market environments
“While the strategy has historically performed well across most of these economic environments, the characteristic that appears to have affected the performance the most is correlation, where the strategy has performed the best during low correlation environments,” the report noted.
In a low correlated market, bet diversification increases, the report authors explained to ValueWalk. When the 67 assets studied are highly correlated in terms of their price activity, this diversification benefit wanes.
This can be seen in the study’s performance breakdown. The worst period of time in the last 100 years of analysis was the most recent. The period from 2010 to 2016, known a time of quantitative suppression, has led to only a 7.6% excess return
The best decade of performance occurred in the inflationary 1970s, when the US abandoned the gold standard and interest rates were pushing the 20% level. During this period excess returns topped 27% while correlation to the stock and bond markets were -0.24 and -0.25 respectively.
Why does Trend Following Strategy perform well during a market crisis?
Perhaps what has most attracted investors to the core strategy is that it has a history of performing well during market crisis. In 2008, for instance, when stock markets were down anywhere from 35% to 50%, managed futures indexes were up near 20%.
How can an investment strategy perform well during market crisis on such a consistent basis?
The key is that major market shifts often take time to develop and then the price trends have a tradeable duration that can be captured by the trend following strategy. The report explains:
The intuition is that most bear markets have historically occurred gradually over several months, rather than abruptly over a few days, which allows trend followers an opportunity to position themselves short after the initial market decline and profit from continued market declines. In fact, the average peak-to-trough drawdown length of the 10 largest 60/40 drawdowns between 1880 and 2016 was approximately 15 months. In contrast, the strategy may not perform as consistently in bear markets that occur very rapidly, such as the 1987 stock market crash, since the strategy may not be able to take positions quickly enough to benefit from sharp market movements in those environments. Nevertheless, the tendency for the strategy to do well on average in major bear markets, while still achieving a positive return on average, makes it a valuable diversifier for investor portfolios.
If these factors that prolonged the time horizon of price movements were not present in markets – as is the case during a flash crash, for instance – the traditional trend following strategy should not be expected to deliver excess returns. There are other technical market environments in which the strategy might find challenging that investors should recognize so that proper performance expectations can be set and investors don't abandon hope in the face of the inevitable trendless market.
Hurst, Brian and Ooi, Yao Hua and Pedersen, Lasse Heje, A Century of Evidence on Trend-Following Investing (June 27, 2017). Available at SSRN: https://ssrn.com/abstract=2993026