Why Trend-Following Works

Why Trend-Following Works

By Larry Swedroe

Similar to some better-known factors, such as size and value, time-series momentum historically has demonstrated above-average excess returns. Also called trend momentum, it is measured by a portfolio long assets that have had recent positive returns, and short assets that have had recent negative returns.

Time-series momentum differs from the traditional (cross-sectional) momentum factor, which considers an asset’s recent performance only relative to other assets. The academic evidence suggests that inclusion of a strategy targeting time-series momentum in a portfolio improves the portfolio’s risk-adjusted returns.

Strategies that attempt to capture the return premium offered by time-series momentum are often called “managed futures,” as they take long and short positions in assets via futures markets—ideally in a multitude of futures markets around the globe.

Today I’ll dive into the time-series momentum factor and examine some of its specific qualities, and those that make a managed futures strategy a good portfolio diversifier.

In general, an asset that has low correlation with broad stocks and bonds provides good diversification benefits. Low or near-zero correlation between two assets means there is no relationship in their performance: If Asset A performs above average, it doesn’t tell us anything about Asset B’s expected performance relative to its average.

The addition of a low-correlation asset to a portfolio will, depending on its specific return and volatility properties, improve risk-adjusted returns by increasing the portfolio’s return, reducing the portfolio’s volatility, or both.

Research From AQR

AQR Capital Management’s Brian Hurst, Yao Hua Ooi and Lasse Pedersen contribute to the literature on time-series momentum through their June 2017 paper, “A Century of Evidence on Trend-Following Investing”—an update of their 2014 study.

In it, the authors constructed an equal-weighted combination of one-month, three-month and 12-month time-series momentum strategies for 67 markets across four major asset classes (29 commodities, 11 equity indices, 15 bond markets and 12 currency pairs) from January 1880 to December 2016. The position these one-, three- and 12-month strategies take in each market is determined by assessing the past return in that market over the relevant look-back horizon.

A positive past excess return is considered an “up” trend and leads to a long position; a negative past excess return is considered a “down” trend and leads to a short position.

In addition, each position is sized to target the same amount of volatility, both to provide diversification and to limit portfolio risk from any one market. Positions across the three strategies are aggregated each month and scaled such that the combined portfolio has an annualized ex-ante volatility target of 10%.

Volatility scaling ensures the combined strategy targets a consistent amount of risk over time, regardless of the number of markets that are traded at each point in time. The authors’ results include implementation costs based on estimates of trading costs in the four asset classes. They further assumed management fees of 2% of asset value and 20% of profits, a traditional fee for hedge funds.


Following is a summary of their findings:

  • Performance was remarkably consistent over an extended time horizon, one that included the Great Depression, multiple recessions and expansions, multiple wars, stagflation, the global financial crisis of 2008, and periods of rising and falling interest rates.
  • Annualized gross returns were 18.0% over the full period, with net returns (after fees) of 11.0%, higher than the return for equities but with approximately half the volatility (an annual standard deviation of 9.7%).
  • Net returns were positive in every decade, with the lowest net return, at 4.1%, coming in the period beginning in 1919.
  • There was virtually no correlation to either stocks or bonds. Thus, the strategy provides a strong diversification benefit. After considering all costs and the 2/20 hedge fund fee, the Sharpe ratio was 0.76. Thus, even if future returns are not as strong, the diversification benefits would justify an allocation to the strategy.

Hurst, Ooi and Pedersen write that “a large body of research has shown that price trends exist in part due to long-standing behavioral biases exhibited by investors, such as anchoring and herding [and I would add to that list the disposition effect and confirmation bias], as well as the trading activity of non-profit-seeking participants, such as central banks and corporate hedging programs.”

They observe, for instance, that “when central banks intervene to reduce currency and interest-rate volatility, they slow down the rate at which information is incorporated into prices, thus creating trends.”

Hurst, Ooi and Pedersen continued: “The fact that trend-following strategies have performed well historically indicates that these behavioral biases and non-profit-seeking market participants have likely existed for a long time.” Why would this be the case?

They explain: “The intuition is that most 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 profit from continued market declines…. In fact, the average peak-to-trough drawdown length of the 10 largest drawdowns of a 60% stocks/40 bonds portfolio between 1880 and 2016 was approximately 15 months.”

They noted that trend-following has done particularly well in extreme up or down years for the stock market, including the most recent global financial crisis of 2008. In fact, they found that during the 10 largest drawdowns experienced by the traditional 60/40 portfolio over the past 135 years, the time-series momentum strategy experienced positive returns in eight of these stress periods and delivered significant positive returns during a number of these events.

While Hurst, Ooi and Pedersen provided results that included a 2/20 fee structure, today there are funds that can be accessed with much lower, although still not exactly cheap, expense ratios.

An example is AQR’s Managed Futures Strategy (AQMRX), which has an expense ratio of 1.15%. The fund targets volatility of 10%. AQR also has a high-volatility version of the fund, QMHRX, which has an expense ratio of 1.58% and targets volatility of 15%. Thus, it’s slightly cheaper on a pro-rata basis. (Full disclosure: My firm, Buckingham Strategic Wealth, recommends AQR funds in constructing client portfolios.)

Additionally, AQR has found that in implementing time-series momentum strategies, their actual trading costs have been only about one-sixth of the study’s estimates used for much of the sample period (1880 through 1992), and approximately one-half of the estimates used for the more recent period (1993 through 2002).


As an investment style, trend-following has existed for a long time. The data from the research provides strong out-of-sample evidence beyond the substantial evidence that already existed in the literature. It also provides consistent, long-term evidence that trends have been pervasive features of global stock, bond, commodity and currency markets.

Addressing the issue of whether investors should expect trends to continue, the AQR researchers concluded: “The most likely candidates to explain why markets have tended to trend more often than not include investors’ behavioral biases, market frictions, hedging demands, and market interventions by central banks and governments. Such market interventions and hedging programs are still prevalent, and investors are likely to continue to suffer from the same behavioral biases that have influenced price behavior over the past century, setting the stage for trend-following investing going forward.”

The bottom line is that, given the diversification benefit and the downside (tail-risk) hedging properties, a moderate portfolio allocation to trend-following strategies merits consideration.

Note, however, that the generally high turnover of trend-following strategies renders them relatively tax inefficient. Thus, investors should strongly prefer to hold such strategies in tax-advantaged accounts.

To read the original article, click here.

The Elephant in the Room: How the Financial Industry’s Shunning of Emotions Fails Its Clients

The Elephant in the Room: How the Financial Industry’s Shunning of Emotions Fails Its Clients

By Tim Maurer

I don’t think professor Richard Thaler is going to return my calls anymore. Sure, he was gracious enough to give me an interview after his most recent book, Misbehaving, a surprisingly readable history of the field of behavioral economics, was published. But now that he’s won a Nobel Prize, something tells me I’m not on the list for the celebration party.

(Although, if that party hasn’t happened yet, professor, I humbly accept your invitation!)

But I’m still celebrating anyway, because Thaler is a hero of mine and I believe that the realm of behavioral economics–and behavioral science more broadly–can and should reframe the way we look at our interaction with money, personally and institutionally, as well as the business of financial advice.

Behavioral Economics In Action

Of course, even if you’re meeting Thaler for the first time, his work likely has already played a role in your life in one or more of the following ways:

  • Historically, your 401(k) (or equivalent) retirement savings plan has been “opt-in,” meaning you proactively had to make the choice–among many others–to do what we all know is a good idea (save for the future). But our collective penchant for undervaluing that which we can’t enjoy for many years to come led most of us to default to inaction. Thanks largely to Thaler and Cass Sunstein’s observations in the book Nudge, more and more companies are moving to an “opt-out” election, automatically enrolling new employees in the plan with a modest annual contribution.
  • Better yet, many auto-election clauses gradually increase an employee’s savings election annually. Because most receive some form of cost-of-living pay increase in concert with the auto-election bump, more people are saving more money without even feeling it!
  • Additional enhancements, like a Qualified Default Investment Alternative (QDIA), help ensure that these “invisible” contributions are automatically invested in an intelligently balanced portfolio or fund instead of the historical default, cash, which ensures a negative real rate return.
  • Some credit card awards now automatically deposit your “points” in an investment account while some apps, like, “round up” your electronic purchases and throw the loose virtual change in a surprisingly sophisticated piggy bank.

No, you’re not likely to unknowingly pave your way to financial independence, but thanks to the work of professor Thaler and others, many are getting a great head start without making a single decision.

What is most shocking to me, however, is the lack of application–or the downright misapplication–of behavioral economics in the financial services industry.

Misusing Behavioral Economics

What, exactly, is being missed or misapplied?

Well, if I had to summarize the entirety of what we’ve learned from behavioral economics, finance and the scientific findings that apply to managing money, it would be the following gross oversimplification of the seminal work from Thaler’s predecessor, Daniel Kahneman, in his book Thinking, Fast and Slow:

1. The brain’s “operating system” for processing information is actually two systems–“System 1 is fast, intuitive, and emotional; System 2 is slower, more deliberative, and more logical,” he writes.

2. Confoundingly, most of our financial (and other) decisions are made with System 1, not System 2.

Even though we may prefer to access the deliberative, logical, quantitative processor in our brain when making financial choices, the science suggests that we’re still using the intuitive and emotional part of our brain to reach those decisions. Let’s say it’s broken down 80/20 into System 1/System 2, emotional/logical, qualitative/quantitative.

However, the financial planning process more often taught and most often practiced is almost entirely System 2–even though the science suggests they’re basically two different neurological languages, and that we struggle to solve a System 2 dilemma with System 1 logic.

(Perhaps this is the reason that more than 80% of the recommendations made by financial planners are not implemented?)

The Elephant (and the Rider) in the Room

This reality is the proverbial elephant in the room, and that’s a perfect analogy because the metaphor that has helped us comprehend Systems 1 and 2 is, indeed, the loveable pachyderm.  Author Jonathan Haidt ascribed System 1 with qualities represented by the elephant, while suggesting System 2 may be characterized by the elephant’s rider.

(I asked professor Thaler a couple years back if he thought this was a fitting and proportionate analogy, and he said it was.)

But a friend reminded me recently that another interesting phenomenon is taking place concurrently. That is, as financial advisors and institutions have been exposed to the science, they’ve been quick to (erroneously) conclude that they are the rational rider and their clients are the emotionally wayward elephant!

Nevermind for a moment that the financial services industry at large has proven its own self-preservative instinct has for too long overwhelmed its nagging feeling that it should put its clients ahead of itself. But to the degree the industry has acknowledged the apparent elephant/rider conundrum, it has chosen to presume that the elephant is a big, stupid animal to be locked outside while the rider reflects self-importantly over a fine, single-malt Scotch at a mahogany board-room table.

“7 Behavioral Biases that May Hurt Your Investments,” “5 Biases that Hurt Investment Returns” and “Investors 10 Most Common Behavioral Biases” are just a few of the first-page search engine results that berate the elephant for its illogical tendencies and seem to encourage the rider to abandon his only form of transportation.

But that’s where we’re reminded half-truths are often the best lies. It certainly is true that we’re prone to all the biases illuminated by the field of behavioral economics. It’s also true that some of these biases lead to poor financial decisions.

Emotions Aren’t the Problem and May Be the Solution

But those who choose to demonize the elephant and elevate the rider do so at their own peril, because it’s also true that:

1. System 1–the elephant–can’t be suppressed. It’s impossible. When the elephant and rider are in conflict, the elephant wins. Period.

2. The elephant is the primary source of our passion, vision and resolve. It can be enlisted to help us accomplish our financial goals.

Those of us who’ve been financial advisors for any length of time know this. If you ask a room of 100 advisors with at least five years of experience how many of them have had a client cry in their office, likely every hand will go up.

We’ve known intuitively for years that personal finance is more personal than it is finance, but Kahneman, Thaler and others have proven it a scientific fact. Others, like Chip and Dan Heath, have helped explain that, perhaps surprisingly, “the Elephant also has enormous strengths and that the Rider has crippling weaknesses.”

In their book, Switch, they continue, “To make progress toward a goal…requires the energy and drive of the Elephant. And this strength is the mirror image of the Rider’s great weakness: spinning his wheels.”

Is that not what we see in personal finance, where financial improvement is one of the top-three failed resolutions every New Year? A lot of wheel spinning? An abundance of talk and an absence of action? A lot of money being made by a financial industry that fails to usher willing clients with means to a beneficial end?

Life Planning and Elephant Training

There is a small niche within the true financial planning profession, which is itself a stunning minority of the broader financial product-pitching machine, dedicated to elephant training. Known by monikers such as “financial life planning” or simply “life planning,” the pioneer in this field is George Kinder.

I recently had the privilege of joining Kinder for his two-day intro course and five-day immersive, experiential advisory training, and I’d coarsely summarize these as intensive training in recognizing, understanding and then enlisting emotions, primarily through compassionate, yet strategic, empathy.

An example of something I learned? When that client (or friend, or family member, or anybody you don’t hate) is overcome with emotion and begins to tear up, you should not–I repeat, not–give them a tissue or (in most cases, but especially with clients) even place your hand on their shoulder.

Why? Because it signals to them that you’re uncomfortable with their emotional expression and want them to stop. We’ve learned that emotions function much like waves that rise, peak and crest, and that we should never avert our eyes–even as a pensive client naturally will–so that when the swell subsides, our appreciative, compassionate, unmoving gaze signals it was totally normal (even welcome) for them to experience that in our presence.

(Then, by all means, give them a stinking tissue!)

And that was just the answer to a common, but isolated, question. In a larger sense, the Kinder Institute has honed this art to a science, giving advisors a deliberate five-step process, and even more importantly (to me), a method for guiding any and every meeting toward the most productive exchange possible.

But Kinder has been influencing the financial planning community for more than 30 years and has trained Kinderites in more than 30 countries. He’s been joined by other respected industry voices, like our five-day co-trainers, Ed Jacobson, Ph.D., and Louis Vollebregt. Others have taken up the torch with their own unique life planning manifestations, such as the late Dick WagnerCarol AndersonRick KahlerDrs. Ted and Brad KlontzSusan BradleyMichael KayMitch Anthony and others.

Every bit of their wisdom that I’ve consumed over the past 15 years has been additive, and I’ve seen financial advisory practices transformed by bolstering their qualitative skills–their elephant training.

Financial Planning Done Right

So, why is it still a niche? Why don’t we see any huge financial firms adopting it? Why don’t we see the Certified Financial Planner™ Board of Standards adding a substantive element of qualitative training to the educational requirements for newly minted CFP® practitioners?

I can only conclude that, in general, the profit motive is still a stronger force within the financial services industry than the desire to put a client’s interest ahead of the firm’s.

But hopefully, with yet another Nobel Prize being handed to a behavioral economist, the qualitative-planning, life-planning, elephant-training movement will continue to grow. And as the growing profession of financial planning begins to separate itself from the sales engine of the larger industry, this is vitally important because life planning isn’t so much a niche or specialty–it’s simply financial planning done right.

To read the original article, click here.

A Primer for Investors “Fed Up” with Rising Interest Rate Fears

A Primer for Investors “Fed Up” with Rising Interest Rate Fears

By Joe Delaney

We have been hearing for some time that interest rates were supposed to rise and yet they have not. You may have heard that interest rates are expected to rise faster under the new Federal Reserve Chairman, Jerome Powell, who will likely replace Janet Yellen in February 2018. (His confirmation is subject to Senate approval, but it is widely thought that Powell was a “safe” pick by President Trump on November 2nd).

While many of the implications of the federal funds rate are mostly of interest to economists and politicians, it is important to understand the potential effect on individual borrowers and investors like you.

What is the Fed?

The Federal Reserve System (a.k.a. “The Fed”) is the central bank of the United States. Their stated mission is to set monetary policies that are intended to do three things: maximize employment, keep prices of goods and services stable and keep financial markets stable as well.

How does it influence the economy?

The main tool in the Fed’s toolbox is control of the federal funds rate. If banks get nervous and slow lending, that makes it harder for individuals and businesses to get funding for lines of credit, inventory financing, etc. To avoid a recession – job losses, home foreclosures, etc. – the Fed lowers the federal funds rate, the cost of borrowing overnight from the Fed’s 12 regional central banks.

If banks are lending too much and there’s too much cash in the economy, it becomes less valuable and prices go up. To counteract this, the Fed does the opposite: it will raise the interest rate to slow inflation. The Fed hasn’t been too keen on doing that since the Great Recession. In fact, their policy of quantitative easing in the wake of the 2008 stock market crash is about as far as you can go in the other direction.

What is quantitative easing (QE)?

When slashing interest rates down to basically free money for banks doesn’t stimulate lending, how do you get money into the economy? QE was the answer for the Fed and other world economies from 2009 through the third quarter of 2014. The idea was to purchase bonds from banks to put more cash in their reserves and encourage money to move in the system.

Many economists have debated QE’s effectiveness. While it seemed to contribute to a reduction in unemployment, its effects on other indicators of economic health have been mixed. It actually raised inflation expectations, for example, a natural consequence of flooding the economy with too much cash. What we know for sure is that the Fed now owns $3.5 trillion more in public debt than they did before 2009 (estimated to total approximately $4.5 trillion today). The next Fed Chair will have a sizeable balance sheet to deal with, and will need to decide how much debt to call in from U.S. banks and how fast.

Why does it matter that Jerome Powell is taking over the Fed?

It’s hard to say whether it will matter much. Janet Yellen has been extremely hesitant to raise rates since the Great Recession, and her successor has generally supported her policy decisions. At most, if Powell raises the federal funds rate a bit faster than Yellen would have, it won’t be much faster. He is not expected to offload debt too fast, either.

While Yellen is more of an economist, Powell comes from a legal, government and corporate America background. The latter has been more critical of Wall Street regulations and he will have more power to loosen them as Fed Chair.

So, what are the implications for investors if rates rise a little faster, or if financial industry regulations are loosened? As so often happens with government policy changes, there tend to be winners and losers. While low interest rates tend to mean more borrowing and business growth, which can improve company stock values, it also means returns on pensions for people with fixed incomes remain low. Regulations are tricky because, while corporate America tends to shun them, too much deregulation can remove important protections for investors.

Bottom line, what does this mean for me?

If the Fed does its job perfectly, it will raise rates at just the right speed to fight inflation without discouraging lending, to keep money flowing through the economy. Stock prices will rise at a steady, predictable rate. Home prices will be at just the right values relative to family incomes.

That’s a fairy tale world, of course.

In reality, we don’t know exactly what effects monetary policy will have on us as individuals. Monetary policies like quantitative easing have had mixed results and probably aren’t going to solve all the economy’s problems alone. If Jerome Powell slashes regulations on Wall Street, it could just as easily add to market volatility as it could stimulate markets in a positive way.

That said, there’s no need to panic. While the federal government can help keep the markets steady from a thirty thousand-foot view, it does not have the answers to keeping your portfolio secure. No matter what the Fed does, always stick to the basics:

  • Have a written investment plan you follow no matter how you’re feeling about the markets moving up or down.
  • Maintain a globally diversified equity portfolio with some low-correlated alternative asset classes (a fancy way of saying don’t put all your eggs in one basket!) and fixed income appropriate to your needs.
  • For your fixed income, set up a bond ladder (a schedule of bonds that mature at regular intervals) positioned to handle the potential for rising interest rates in the future.
  • Figure out how much risk you need to take and don’t exceed your risk tolerance.

All this comes not from becoming an expert on economics and U.S. monetary policy, but simply from making an appointment with your trusted financial advisor. If you’re ready to have that conversation, call Lifeguard Wealth today. We are here to help.


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The opinions expressed by myself and other featured authors are their own and may not accurately reflect those of Lifeguard Wealth. This article is for general information only and is not intended to serve as specific financial, accounting or tax advice.
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