Like to Dislike Trend Following

By Moritz Seibert, edited by Niels Kaastrup-Larsen

Everyone involved in the systematic trend following business has probably heard it many times, and I have heard it again last week: “Why invest with you when I can buy and hold the DAX for zero cost and, when holding my position for a number of years, I always end up making money?”

First, I still need (and want) to meet the investor who has truly held the DAX for years and years without interfering a single time. Consider a 10-year time period. Looking at a 10-year chart and interpreting what you see as “real” performance is one thing. But actually achieving that performance is quite another, because it requires you to stay away from the markets and do absolutely nothing for 10 years. Yes, do nothing! However, sitting still is a difficult thing to do when the alternative is to participate in some seemingly exciting price action, attempting to outsmart the market. Doing nothing means you don’t panic during crises and you don’t get overwhelmed during strong bull markets. If you can manage to do that, then that’s true buy and hold (and hope). Sounds easy, but it’s very tough in practice. So, does your personal equity index performance really look as good as the charts you are looking at?

Second, comparing the performance of a single equity market to a large, multi-asset trend following program misses the point. It has no relevance. It makes no sense.

Discussions of that sort give me the impression that some (maybe most) investors like to dislike trend following.

"It’s a love-to-hate relationship!"

It seems there’s a strong mental desire to avoid it. How can it be that a price-based system designed to buy highs and sell lows outperforms the fundamental trader who studies and analyzes the markets each day? How can it be acceptable that simplicity can do better than complexity? It’s hard to embrace that. And so, rather than accepting the facts (e.g., by reviewing the multi-decade performance record of the CTA industry), the preference is to manufacture new arguments against trend following, the latest of which is “trend following is just beta.”

It’s so easy to say this sentence, but it’s lacking deeper thought. How can a trend following system that dynamically trades in and out of multiple markets, long and short, with different entries and exits at different points in time, be pure beta?

"The answer is…it can’t"

The notion that trend following has turned into beta seems to be a result of indexation as several trend following indexes, some fully transparent, have emerged during the past couple of years. These indexes aim to replicate the performance of certain trend following strategies at lower costs; however, index-based replication does not equal beta. A pure beta return stream cannot produce better risk-adjusted returns than the market to which it relates. That’s because it is identical to such market.

Take the “smart beta” industry, for instance. Smart beta indexes exist to give investors something better than pure beta, i.e., to produce a certain amount of alpha. With respect to equities, smart beta equity indexes cannot comprise all outstanding shares because they are not weighted by market capitalization (any deviation from a market capitalization-based weighting represents a certain part of the market, but no longer the complete market). Hence, there must be an alpha component in any smart beta index -- whether such alpha component yields something to the investor and whether it is priced fairly is a separate question.
The same is true for trend following indexes, i.e., there’s alpha in these indexes. But, when trading rules are spread to the market and replication becomes possible, then the alpha is no longer unique and the price for these trading rules drops (maybe even to zero). But this does not mean that alpha has turned into beta.

"Investors seeking to maximize their trend following alpha should instead turn their attention to managers which have demonstrated that they can outperform trend following indexes over many years net of fee"

(even if the required due diligence means a bit of extra homework compared to an index investment).