Trend Following Strategy Offers Resilient Portfolio Protection

Investors often seek strategies to protect their portfolios during market downturns. However, many of these strategies resemble portfolio insurance, facing challenges in benign markets and even negative long-term returns.

Trend following, a strategy used by the managed futures industry, aims to provide both positive returns and downside protection. It can profit in rising and falling markets, making it valuable for investors with long-only equity or fixed-income exposures, especially when market conditions become challenging.

A strategy for all seasons

During the high-inflation period of 2022, when stock and bond markets struggled, managed futures generated strong returns by betting against these markets. This ability to turn uncertainty into profit is a powerful tool for building resilient portfolios, particularly in volatile macroeconomic environments.

Unlike long-only equity strategies, managed futures can adjust long and short positions, profiting across various environments. They use a multi-asset approach, taking advantage of trends in equities, fixed income, currencies, and commodities, allowing for dynamic portfolio adjustments.

For instance, they might use equity index futures to bet on a country’s equity market, such as the ASX 200, interest rate futures for short-term rates in Canada, or currency forwards for exchange rate views between the euro and the Australian dollar. This flexibility enables the strategy to capitalize on diverse market conditions.

The science behind trend following

Trend following works because investors don’t always react immediately to new information. This underreaction creates persistent asset return trends, which the strategy exploits by identifying improving or deteriorating price trends, leveraging the delayed market response to news.

While no strategy is perfect, trend following may struggle when markets reverse sharply, potentially giving back some gains before signals adjust. However, its ability to profit from sustained declines and other opportunities provides valuable diversification without sacrificing potential upside, making it a robust addition to portfolios.

Expanding the investment universe beyond traditional markets can enhance managed futures strategies. By including new asset classes and sophisticated models, investors can capture a broader set of opportunities, potentially improving returns and reducing reliance on conventional markets.

Read Also: Bank hybrids start to disappear for investors

For example, adding yield-curve strategies or equity-market-neutral factors like profitability can provide attractive, diversifying return sources. This expansion allows investors to benefit from trends in less traditional areas, further strengthening their portfolios by accessing unique market forces.

Expanding Horizons: New Markets, New Opportunities

Managed futures strategies traditionally focus on well-known markets like equity indices, government bonds, currencies, and index commodities. While these offer significant opportunities, they aren’t the only places where trends emerge, and expanding the investment universe can uncover additional sources of returns.

However, adding exposures like yield-curve strategies or equity-market-neutral factors requires sophisticated modeling and trading expertise, ensuring robust and effective implementation.

For instance, during a rallying equity market, a traditional trend strategy would simply go long. But if the rally is driven by highly profitable companies, a trend-following strategy focused on profitability could offer a different opportunity by going long on quality-oriented companies and short on lower-quality ones, providing a subtle approach to market trends.

Enhancing Trend Identification

Instead of relying solely on price trends, these strategies can incorporate economic and fundamental data to capture news directly, providing a more full view of market forces.

For example, growth trends can be measured by changes in forecasts for economic releases or corporate earnings. This approach allows strategies to identify trend opportunities earlier and respond more effectively to market conditions, enhancing both timing and accuracy.

This is particularly valuable at turning points. Signals capturing inflationary trends and hawkish monetary policy in 2021 and 2022 led to bearish shifts in equity and interest rate positioning earlier than price-based signals, resulting in stronger performance during the subsequent sell-off, demonstrating the strategy’s adaptability.

By integrating economic trends, managed futures strategies can improve both average returns and downside protection during bear markets, offering a more robust approach to portfolio management.