Trend following strategies: why now?
Increased volatility in traditional portfolios – owing to geopolitical tensions and increased inflation risk, among other factors – has prompted investors to explore alternative strategies. Could trend following be an answer?
Autheurs
In an evolving financial landscape characterised by increased volatility and a shifting macroeconomic regime, trend following strategies have regained prominence. Trend following is a systematic investment strategy that seeks to capture profits by riding sustained price trends across a diverse set of asset classes. It is one of the most well researched and out-of-sample proven approaches to generating diversifying returns.
Schroders has been investing in and running trend strategies for over a decade. These strategies can enhance portfolio performance and offer unique diversification benefits over the long term due to their ability to adapt dynamically to market shifts regardless of direction, their ability to take both long and short positions, and their broad investment universe.
More recently, bonds have become a less reliable portfolio diversifier, increasing the volatility of the traditional benchmark portfolios and the need for broader sources of return. This paper explores the advantages and risks of trend following and its role as a strategic allocation to long-term investors, highlighting its importance in today’s complex investing environment.
What is trend following?
Return diversification:
Traditional portfolios often emphasise equities and bonds, leading to concentrated risks. Trend following introduces a systematic approach to generating returns that can trade across various markets and asset classes, including equities, commodities, currencies, and bonds. For example, a trend following strategy with exposure to commodities presents a good way to access the return and inflation sensitivity of commodities without the downsides of benchmark driven allocations.
This broad diversification mitigates the risk of overexposure to any single asset class, sector, or region.
Adaptability during regime shifts:
Unlike static or long-only constrained investment approaches, trend following strategies dynamically adapt to changing market conditions. The strategy identifies and capitalises on price momentum in a wide range of asset classes and makes use of its ability to take both long and short positions.
This flexibility allows trend followers to profit in both bull and bear markets. Historically, it has generated positive returns during prolonged market downturns without sacrificing long-term returns. This characteristic makes trend following particularly attractive during bear markets in equities or bonds, especially when they occur simultaneously.
Liquidity:
Trend following strategies operate in highly liquid markets allowing positions to be adjusted quickly as market trends shift, making the strategy agile and adaptable. Unlike other alternatives such as private equity or real estate, which can lock up capital for extended periods, trend following offers the liquidity to scale and incorporates seamlessly into portfolios.
Its flexibility enables investors to adjust exposure in response to broader portfolio capital needs, making it a valuable liquid alternative.
Systematic, objective and cost-effective:
Trend following inherently takes a rules-based approach. This removes emotion from decision-making, reducing exposure to behavioural biases. By following predefined rules that consider signal construction, risk control and portfolio diversification, trend followers systematically enter and exit trades based on price trends. This discipline not only offers transparency and consistency, but is crucial during periods of regime shifts where our perceptions of the market environment are perhaps still anchored to an old regime.
All of this can be delivered in a cost-effective way for the end investor.
Why now? The case for trend following in today’s environment
The current market environment presents unique challenges to the traditional 60/40 portfolio – the long-established model that combines 60% equities and 40% bonds. Key risk drivers in this conventional structure, particularly volatility and inflation, are becoming more unpredictable, prompting investors to explore alternatives like trend following. While we do not advocate tactically timing trend, here is why trend following is particularly relevant in today’s market environment.
Increased portfolio volatility:
The past few years have seen a notable rise in volatility for traditional portfolio approaches, driven by geopolitical tensions, monetary policy shifts, uncertainty in global growth and a shift in the correlation between equities and bonds that has made it harder for equity/bond portfolios to navigate uncertainty in markets.
This has meaningfully reduced the Sharpe ratio of standard portfolio approaches and increased the strategic role trend following can play in delivering both return and diversification in a portfolio.
Inflationary pressure:
Inflation risk has re-emerged as a dominant theme in global markets, and despite the most acute period coming to an end, the era of ultra-low inflation seems to be waning. Inflation uncertainty is equally a concern alongside growth uncertainty. Trend following strategies have historically performed well in inflationary regimes, as they can go long in asset classes like commodities, which tend to outperform when inflation risk turns into sticky price pressure.
Challenges for bonds in the 60/40 portfolio:
Today we are arguably past peak inflation in the post-COVID era, but we are not past structurally higher inflation risk.
As a result, the fixed income portion of the 60/40 portfolio is expected to remain under pressure as a return generating diversifier. The previously common negative correlation between equities and bonds has moved towards positive levels, further eroding the diversification benefits of the 60/40 split. Trend following provides an alternative source of diversification, reducing reliance on strictly long bond positions for risk mitigation.
Historically, where bonds are perceived as good diversifiers, trend following strategies exhibit greater correlation to bonds, behaving as a good diversifier too. On the contrary, during periods of a positive equity/bond correlation, with diminished diversification benefits of bonds, trend following has the potential to take short positions and provide better diversification (Figure 1, below). As a result, trend following strategies have performed well in many of the worst months for the 60/40 portfolio (Figure 2).
Figure 1: Higher trend/bond correlation during times when it benefits the portfolio
Figure 2: Trend following displays better performance than 60/40 portfolios during market routs
Trend as a strategic allocation
Trend following is a medium-to-long-term strategy. It generates positive return over the long term that is similar to that of equities, but with a very low correlation to the benchmark portfolio.
Figure 3: Correlation versus 60/40 over the last 10 years1
Over the past 30 years, incorporating a trend following strategy alongside a typical 60/40 portfolio would have been additive to an investor’s returns, creating a much-improved risk-reward payoff with both an increased return and a reduced volatility.
Figure 4: Long-term returns of 60/40 versus 55/35/10
In addition, the systematic approach inherent in trend following strategies fully neutralises any emotional biases. The capacity of trend following strategies to navigate complex market landscapes offers a significant advantage as a complement to a 60/40 portfolio.
What does risk look like in trend following?
It is important for investors to understand that there will be periods of drawdown, just as in any other strategy. Trend following strategies assess the movement of assets over a defined window in the past and require price movement to persist into the future. If this is not the case – for example, if trends start and subsequently reverse – the strategy will be unable to profit or even generate losses.
Figure 5: Crisis, correction and trend following returns
Figure 5 (above) presents trend returns in historical equity (S&P 500 Index) drawdowns from 1980, where x-axis is the length of the drawdown. It shows that trend following strategies perform better in sustained downturn and dislike short-term shocks.1
Risk management framework
A fundamental difference between trend following strategies and a conventional 60/40 portfolio allocation lies primarily in their risk management frameworks and responsiveness to market dynamics. Trend following strategies start with risk management; they continuously assess market signals and prevailing risks, enabling positioning adjustments based on trade-offs between trends capture and risk control. In particular, the strategy often employs volatility-adjusted position sizing, meaning positions are adjusted based on the riskiness of the asset.
The flexibility that allows trend following to capture upward price momentum while also positioning itself defensively against declines, has benefited portfolios incorporating trend following strategies during volatile periods. This is evidenced by trend following’s low realised correlation to a 60/40 portfolio, particularly during an equity downturn.
Additionally, a self-correcting property of signals that naturally reduce when the market moves against them are typically employed to limit downside risk and exit positions when trends reverse. This helps preserve capital and ensures that no single position can have an outsized negative impact on the portfolio.
Investor behaviour
Some end investors are finding it challenging to allocate to and hold onto trend following strategies2. There are several reasons for this:
- Trend following tends to deliver returns in an uncorrelated and sometimes counter-intuitive manner, meaning that it may underperform directional exposures during bull markets with brief corrections along the upward trajectory. This can lead to a sense of opportunity cost, especially when traditional assets are delivering strong returns, causing investors to question the value of maintaining their trend exposure.
- The strategy’s returns, especially those in a single asset class, can be lumpy, with periods of flat or negative performance happening in between periods of strong performance, testing the conviction of investors who may struggle to tolerate short‑term drawdowns while pursuing long-term gains.
- The strategy can be misunderstood or seen as complex due to the use of mathematical models, making it harder for some investors to fully appreciate its role in diversifying a portfolio and protecting against large and unforeseen market moves.
We recommend investors focus on long-term objectives of incorporating a trend following strategy in a portfolio. Investors should strive to avoid short-term timing biases and instead focus on assessing opportunities and risks related to directional betas within their broader portfolio.
Conclusion
Over the last few years, portfolios focused on exposure to equity and bond beta faced a much more challenging environment, from rising volatility to inflation risk and diminishing diversification from bonds. 2024 provided some hope that we may return to the old days of negative equity-bond correlation, but recent market dynamics remind us that while the level of inflation is now lower, inflation uncertainty remains elevated, and the current regime is markedly different from the last decade.
In this environment, investors must diversify beyond traditional assets, and a multi-asset trend following portfolio presents a compelling solution. Its ability to adapt to market conditions, provide positive performance during sustained equity drawdown and maintain liquidity makes it an attractive strategy in today’s uncertain markets; whether in traditional hedge fund form or, like our approach, in broadly accessible UCITs solutions.
For investors, trend following offers not only diversification but also an opportunity to enhance returns, reduce total portfolio risk, and achieve better overall portfolio resilience for the long term. We don’t advocate trying to tactically time trend following allocations; but if you are new to trend following and considering your first strategic allocation, or already allocated and considering a top-up, there may be no time like the present.
Sources:
1Kathryn Kaminski and Yingshan Zhao, Crisis or Correction: Managing Expectation for Managed Futures and Crisis Alpha, 2023.
2Morningstar. ‘Market wizards wave their wands but investors miss the magic’
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