Tuesday, October 23, 2012

Another Study Showing Trend Following Works

A Century of Evidence on Trend Following

Great study done by AQR showing that trend following has produced consistent profits since 1903.   Some powerful points made by the study:

1. If you look at the ten largest drawdowns in a classic 60/40 portfolio since 1903, a trend following portfolio (as designed in the study) would have had positive returns in 9 out of 10.

2. Trend following works very well in Bear Markets because:
"The intuition is that the majority of 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 profi t from continued market declines."
The paper also rightly points out the many trend following strategies have had trouble over the past few years.  While this is not out of the norm looking back to 1903 it still makes sense to explore the reasons why.
Trend following does best when there are consistent longer term trends, the investor can get in after a trend has been verified and hold on until the trend reverses.  If you look at just the monthly returns of the S&P 500 over the past 3 years, the risk on/risk off markets created by the European crisis have made it difficult to follow a trend following strategy.  For example in 2010 February through April the market had a great run, only to be down 7.99% in May and down 5.23% in June.  We see the same pattern in 2011 and 2012 where it looks like an uptrend is forming, only to be followed by a quick reversal.   Depending on the time frame the trend follower is looking at, he or she might get into the market because of  a large up move just in time for the reversal (of course this argues for varying your time frames). 
Have markets fundamentally changed so that trend following is no longer viable?  Not at all.  It is human nature to create trends.  Markets are not rational or efficient.  When investors see something going up they pile in.  It is only the complexities of the European situation over the past couple of years that has caused trendless markets.  This will either pass, paving the way for a market rally, or drag us down into a massive market decline.  Either way, trend following wins.

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