Trend following attempts to mine and filter irrational participant behavior, but it has challenges itself - specifically whipsaws and rudderless markets that generate false positive reads on the trend. These false positives, if not managed and understood, can actually create worse behavior by investors. We attempt to mitigate these.
Whipsaws and rudderless markets show up the same way - an unnecessary trade where you sold low and bought higher. If you go in knowing this will happen from time-to-time, but serves a purpose, it makes it easier to swallow. It’s part of the evidence-based, rules-driven process.
Complement Strategic Trend-Based Asset Allocation with Tactical Trend-Based Risk Allocation
Most trend strategies are binary - all in or all out. I employ two different approaches. My Strategic approach needs two signals to go risk off - (1) Is the Total Market Index/Aggregate Bond Index Price Ratio Fast Moving Average below the Slow Moving Average, and (2) Is the unemployment rate greater than the three year moving average of the unemployment rate. If both conditions are met, then the portfolio will swap some equity assets for fixed income assets.
Here is an example of all in or all out - no employment filter - the past 10 years.
With a very unattractive risk-return profile - you would leave nearly half the returns on the table. That is expensive insurance.
However, look at how this changes when you extend the time period to 12.5 years back to February 2007.
This shows that trend following can add value, but we need to filter those false reads in the past 10 years to obtain it. Doing so would even improve upon this backtest. If we added an unemployment rate filter, this trend could avoid a lot of false reads.
My Tactical approach identifies an “Offensive” and “Defensive” position. I still use the Price Ratio between offense and defense, but I am able to capture a lot of downside protection, while still participating on the upside for any false reads and maintain my asset allocation discipline - albeit at a different risk when price behavior suggests. This different lens allows me to manage and reduce the downside of trend strategies. Here is an example of my Emerging Markets position. By migrating from a binary all in or all out approach to a dynamic offense-defense approach with all asset classes, you add another degree of diversification.
That said, the trend strategy will still not find perfection, just direction. It is also important to understand the cost of being wrong and how to frame any actions in changing your trend equity position. You must know the intent and compare that to an emotional and dollar-based cost-benefit and decide if it is worth it.
Trend Equity should provide emotional air cover
Trend Equity should offer a short-term insurance policy on your portfolio - this insurance policy is the cost of being wrong and that being acceptable compared to the risk experienced over a lifetime. You have a lot of insurance that you never use. Trend Equity intends to offer insurance against big losses while costing you a little from time to time with no benefit.
Does the trend approach of “buy and mold” exceed the value of “buy and hold”. This can fall anywhere on a spectrum of emotional peace of mind and risk adjusted return. In either case, client transparency of what you are doing and why you are doing it, should be part of the process that builds the trust in your inputs and outcomes.
Understanding simple, but effective tweaks to trend equity strategies and understanding the purpose and process behind them can make trend equity concept an attractive complement to a passive index approach.