Some of the strongest track records in money management are closely bound up with trend-based strategies. Yet by the standards of most investment anomalies, trend following’s results should have faded into mediocrity years ago. Why has it beaten the odds? Several experts in the niche offer their thoughts in the newly published fifth edition of Michael Covel’s Trend Following.
A study – “Two Centuries of Trend Following” — republished in the book by several authors at Capital Fund Management documents that trend following’s persistence as a successful strategy is not only highly significant in a statistical sense, it’s also widespread across asset classes. It adds up to “one of the most statistically significant anomalies in financial markets.”
The fact that the strategy has been applied by investors for centuries in one form or another only enhances the allure. No wonder that there’s an ever growing pile of money in portfolios tracking trend-based strategies. ETFdb.com lists 39 “momentum” ETFs that collectively manage well in excess of $10 billion—and that’s just the tip of the iceberg. Add in hedge funds, managed futures, mutual funds, and other portfolios that routinely deploy trend following strategies in various guises and it’s easy to imagine that the niche is home to $100 billion in assets under management, and perhaps that’s a conservative estimate.
Despite the popularity, trend following’s prospects remain bright, according to many analysts. Investors generally agree, or so the expanding pool of money in this corner of finance suggests. There are dry patches from time to time, but hardly anyone thinks that strategies linked to trending behavior have passed their prime.
Why hasn’t the ability to make money in this niche been arbitraged away? There are many theories. Jean-Philippe Bouchaud, founder and chairman of Capital Fund Management, offered his perspective in an interview with Covel in Trend Following, advising that “traders on aggregate using trends is probably the reason why trends are there in the first place, and people using trends have been around for 200 years.”
Trending behavior in asset prices, in other words, is self-perpetuating, he reasons. “Trend followers… create these trends,” Bouchaud explains.
If so, the strategy’s growth, in contrast with other strategies, may actually strengthen and expand the opportunities.
In another interview in Trend Following, Alex Greyserman, a member of the ISAM Systematic Trend Investment Committee and the author of Trend Following with Managed Futures: The Search for Crisis Alpha, says that the strategy’s persistence satisfies a particular demand in the marketplace. He tells Covel that “what trend following is actually doing is providing liquidity to hedgers, and it’s creating an equilibrium in the markets, and we have to get paid for that.”
That is why this has worked for 800 years. If the price of oil, for example, is going up… the airline companies will almost certainly need to sell oil to lock in the future price. They’re not in the business of counter-trend trading; they just need to sell it to lock in the future price.
We at that point buy it—it gets just a little technical but it’s conceptually establishing the fact that it’s a natural occurring concept. The markets need players like us, otherwise you will have a whole bunch of hedgers and the markets won’t exist.
Greyserman adds, however, that a trending strategy “cannot be, when you think about evolutionary things, it cannot be a free lunch. If I made money in every single trend following trade, the hedgers will stop hedging.”
The main takeaway, Greyserman emphasizes, is that “it’s the equilibrium of the markets that establishes this principle and that’s what makes it work over 800 years.”
Trend following is almost unique in that area. A lot of convergent-type strategies are very limited in their capacity, very limited in what they can do, because if five other people discover it, it could be gone.
Trend following, by contrast, is widely embraced. Yet it survives as a viable strategy because, as Greyserman insists, “It’s a naturally occurring phenomenon in the markets… It almost cannot go away. It can temporarily not work but it just structurally cannot disappear….”