Ideas & Debate

Trend following could also make you good money

Investors should know that past performance cannot guarantee future results. FILE PHOTO | NMG
Investors should know that past performance cannot guarantee future results. FILE PHOTO | NMG 

Fundamental strategies enjoy near cultic support inside the investment community. Locally, there is no shortage of players who believe this method is the Holy Grail of investing. We’ve all seen the performance; the conclusion is clear – value-investing has proven its worth.

But is it the only game in town? Is it the cream of the crop as some say? I doubt it. I come from a school of thought that believes there are many paths up the investment mountain.

As Charles Kingsley, the famed 19th century Anglican priest, would’ve said it: “There are more ways of killing a cat than choking it with cream.” In today’s article, I’d like to share a different strategy—trend-following.

For starters, trend-following as investment strategy follows an old maxim that you should allow your winners to run but cut your losses short.

Its goal is to reduce volatility and the potential for large portfolio drawdowns. A key point about this strategy is that it purely focuses on one indicator; price.

Trend followers don’t bother with forecasts, they simply follow the price. It’s for this reason that trend followers never buy at the bottom or sell at the top – they only seek to capture the fat in the middle.

That said. Roughly 12 months ago, a critical research paper was released by the AQR Capital management—A Century of Evidence on Trend-following Investing—showing the robustness of this strategy.

After running tests in 59 markets across four major asset cases – 24 commodities, 11 equity indices, 15 bond markets and 9 currency pairs—from January 1903 to June 2012 using an equal-weighted combination of 1-month, three-month and 12-month time series, the researchers got results that were super impressive.

The test, net of simulated transactional costs, returned 20 per cent (gross of fee) and 14.3 per cent (net of fees) with a 9.9 per cent annualised volatility and a Sharpe ratio of 1. The message was clear; the strong performance of trend-following is not a statistical fluke. 

More interestingly, the paper also made several observations that were quite fascinating about long-term trends. Key amongst them was that price trends exist in part due to long-standing behavioural biases exhibited by investors, such as anchoring—occurs when investors fix their fair-value estimates on purchase prices as opposed to fundamentals even in the face of losses—and herding.

Investor herding is a well-known phenomenon locally (recall the heady years of 2006/7). Equally interesting was the fact that the trading activity of non-profit seeking participants such as Central Banks contributed immensely to trends.

Here’s the gist: trend-following is indeed a worthy investment tool just like the fundamental approach. And to those of us who are not mathematically-inclined, trend-following is a powerful alternative.

To those doubtful of company books integrity, trend-following is a better (if not superior) option.

But take caution—while the strategy has consistently performed well for over a century, investors should know that past performance cannot guarantee future results.