Building a better portfolio with trend-following strategies

by Jason Zhang, CFA, Portfolio Manager, SLGI Asset Management Inc.

In my previous article, I explained how adding alternative asset classes and strategies could potentially benefit a portfolio of traditional equities and fixed income. Adding alternatives can help diversify portfolios and enhance their risk-adjusted returns. A trend-following strategy is one such alternative solution.

Investors’ behaviours drive market momentum

The momentum theory of investing underpins a typical trend-following strategy. Momentum theory, which was discovered 30 years ago, [1] suggests that assets that have performed relatively well compared to other assets tend to continue to outperform, and assets that have performed poorly tend to continue to underperform.

Behavioral explanations are cited to support momentum theory: information takes time to disseminate in financial markets and investors only slowly adjust to new information as they remain heavily anchored to their prior beliefs. As more investors adapt to the new information, a positive feed-back loop reinforces an asset price’s existing trend. For example, an asset that has risen continues to rise.

This situation continues to a point where there are no more investors willing to buy the asset. The trend then inevitably reverses itself. This repeating process results in some remarkable price waves.

Capitalize on the trend

A trend-following strategy can systematically identify trending behavior across a range of assets including commodities, equities, fixed income, and foreign exchanges, and capture those returns due to the trends. It could potentially generate positive long-term absolute returns regardless of overall market direction.

Further, since the return drivers of trend-following strategies stem from investors’ behaviors, they are fundamentally different from that of long-only strategies, which benefit from the risk premia associated with an asset class. As a result, trend-following strategies help diversify portfolios by mitigating against systemic risk from equity and interest rate markets. In short, trend-following and long-only strategies are negatively correlated.

In times of distress, look for “crisis alpha”

The diversification effects of the trend-following strategy tend to kick in strongly during periods of market distress. As many investors may feel financial or psychological pressure to sell assets during times of crisis, trend-following strategies try to position themselves along dominant trends on a cross-asset basis. This helps the strategy benefit from extreme price moves as volatility rises. As a result, a trend-following strategy can often deliver the so-called “crisis alpha,” or downside mitigation, to a portfolio’s overall return.

Investors may ask why we don’t hold a big portion of our portfolios in a trend-following strategy. The answer lies in how we expect investment outcomes to play out in the context of a typical asset allocation portfolio. Markets tend to switch between trends and consolidations. It’s no secret that consolidations are the main detractors of trend-following strategies as frequent price reversals introduce false signals and reduce profit potential.

Based on our modelling we believe a moderate allocation to a trend-following strategy within an overall alternative investment bucket that complements traditional equities and fixed income assets, delivers superior risk-adjusted returns.

In summary, we believe that a trend-following strategy can bring a distinct and time-tested return driver, to complement our exposure to traditional stock and bond in the portfolio.

[1] Jegadeesh, N., and S. Titman. 1993. “Returns to Buying Winners and Selling Losers: Implication to Stock Market Efficiency.” Journal of Finance, 48, 65-91.

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