Following trends: the key to tracking market rises but avoiding falls

by Andrew Clare, Stephen Thomas on Jan 17, 2011 at 07:00

By adopting trend-following rules, investors can beat the index with lower volatility across a range of asset classes and markets, say professors Andrew Clare and Stephen Thomas of Cass Business School.

The holy grail for investors is a fund manager that can produce alpha, a manager who can consistently outsmart the market. Unfortunately finding such a manager is a bit like trying to find a cab on a wet, wintry evening: you know that they’re out there somewhere, but try as you might they remain hidden from your view.

The academic literature does not give much encouragement. Paper after paper has been published on the performance of the active fund management industry showing that most managers cannot produce alpha by timing the market on a consistent basis.

Furthermore, while positive performance is fleeting, there is overwhelming statistical evidence to suggest that negative performance is persistent. Put your faith in a fund that has had a good year, and it might perform well for you next year, but put your faith in a poorly performing fund and it will almost certainly perform poorly for you the following year.

It is for these reasons that many investors, both retail and institutional, prefer the passive route. It is cheap and at least it gives investors the beta they really want. After fees, two thirds of passive funds regularly outperform their active competition. However, the obvious problem with buying passive beta is that as well as tracking the market up, this strategy slavishly tracks the market down too.

Limitations of market research

The textbook approach to managing risk steers investors away from narrowly focused long/only equity portfolios and recommends diversification into a (hopefully) uncorrelated, multi-asset world.

However, the recent financial crisis has cast doubt on the efficacy of this in practice as previously uncorrelated assets all moved down together as liquidity became an issue. Other extensive equity market research has indeed identified features of stocks such as momentum and value that do seem to offer positive, risk-adjusted returns but which are unable to offer positive absolute returns over reasonable holding periods when markets are under stress.

So why hasn’t sophisticated portfolio mathematics and computing suggested ways to combine assets into portfolios to overcome these failings? After all, massive computer power in the hands of highly qualified mathematicians held great promise and has indeed led to successful trend-following commercial products, though again the financial crisis exposed these to unanticipated hits.

The basic problem is that so-called ‘optimised’ portfolios have a nasty tendency to go massively overweight the asset class about which the analyst is most optimistic and imposes one’s human overlay; given the poor record of the industry in forecasting returns this leads to an inevitable own goal. A simple alternative, which is featuring in the research literature, is for managers to equally weight their chosen asset classes.

Investor psychology

Recent research conducted by US academics and at Cass Business School, shows that there is a plausible alternative for investors dissatisfied with the search for active alpha and who want to avoid tracking the market down with their passive holdings. This research is anchored firmly in the ideas that have sprung from the new discipline of investor psychology. Far from behaving like super intelligent, rational robots investors make mistakes. And worse still they are prone to repeating these mistakes over and over again.

Our research, conducted using a variety of different asset classes and over a range of different sample periods and countries, and which confirms the results of similar experiments undertaken by US researchers, shows that a combination of trend following and momentum-based rules can produce alpha on a consistent basis.

The common result in all of these experiments is that these rules generate investment returns over the long term that are as good as those produced by a buy and hold strategy, and often better. But more importantly, the returns they generate have volatility that is typically two thirds of that produced by an equivalent buy and hold, passive strategy.

Research by US studies into these ‘trend following’ rules has shown that while the annual return on the S&P 500 from 1900-2008 was 9.2% with a volatility of 17.9%, the returns after trend following rules had been applied were 10.65% with annual volatility of 12%. Similar improvements in risk and return have been demonstrated for a wide range of asset classes.

How the outperformance is generated

The rules generate this outperformance in a number of ways. First, the rules track the market up when it is trending up, but switch the investment into cash whenever the market is trending down, thus avoiding the main pitfall of passive investing.

Second, the rules can be applied to a wide range of asset markets simultaneously, from broad equity indices to bonds and commodities markets therefore giving the investor access to the one free lunch in finance – diversification.

Third, the rules can integrate the benefits of equally-weighted investing with the more widely known advantages of regular portfolio rebalancing. As indicated above, research has shown that sophisticated optimisation techniques aimed at identifying optimal asset weights are nearly always outperformed by a simple equal weighting of the investments under consideration.

By regularly rebalancing a portfolio to maintain the equal weights across a diversified portfolio, one is constantly selling those assets that have outperformed and investing in those that have underperformed, that is, buying low and selling high, which is always a good rule to follow!

Beating the deflationary blues

Those investors worried that we might be heading for a Japanese style scenario over the next few years will take heart from the chart shown below.

The red line in the chart shows the result of applying these rules to just one market, the Japanese equity market. The blue line simply represents a passive holding in the same market.

In local currency terms the passive, buy and hold strategy returned 0.63% per annum with a volatility of 20% per annum; the trend following rules produced a return of 4.6% with volatility of 13%. The performance is impressive, especially when one considers that this simple strategy cannot, by definition, have been enhanced by portfolio rebalancing or diversification. If the developed world really is in danger of slipping into a Japan-style environment then this strategy may be particularly useful for beating the deflationary blues.

A possible way forward

With absolute return funds offering expensively managed non-protection, and diversification and passive investing offering more volatility than may be desired, a cost effective alternative grounded in recent finance research is available.

This investment strategy, with its in-built risk management strategy, is likely to offer a genuine alternative to those investors disillusioned by high active fees and poor active performance, or who do not simply want to track the market down as well as up.

Our conclusion is clear: why wait for a cab when a driverless pre-programmed mass transit system can take you more safely and cost-effectively to your destination?

Notes …

* This newsletter has been prepared with all possible care to ensure its accuracy. It is based on our current understanding of legislation and HMRC practice. 
* Neither Aisa Direct Ltd nor any of its employees can accept responsibility for any errors or omissions. You should seek further professional advice prior to action.