Today’s post looks at a recent paper from MAN on how much trend following to include in your portfolio.
Honey, I Shrunk the Trend Following
For reasons that I hope will become clear, the paper is called “Honey, I Shrunk the Trend Following”.
- The subtitle is clearer: “How much trend-following should investors hold in a portfolio?”
The paper was published in April 2024 and begins by listing trend’s desirable properties:
Comparable long-term returns to equities, zero long-term correlation to traditional assets, and historically-observed strong performance in crisis periods.
So how much trend do you need?
The textbook answer would be the proportion that generates the optimal risk-adjusted reward, or Sharpe ratio.
However, MAN feels that real-world constraints could shrink this allocation (hence the title).
LOMA
As a baseline, MAN uses a typical long-only multi-asset (LOMA) allocation – a global 60/40 stock-bond portfolio.
- This was a great portfolio until recently, with both assets rising in price and low correlations between them.
But correlations have now turned positive, something that used to be quite common.
This only makes the argument for adding trend as further diversification more powerful.
Optimal Sharpe
The chart shows the optimal combination (that produces the max Sharpe) for a variety of lookback periods (to December 2023).
- Lookbacks shorter than three years become very noisy (and allocations to trend very high, given the outperformance post-2022).
The optional allocation ranges from 20% to more than 60%, or 50% if you stick to periods longer than 10 years.
- MAN settles on 40% as the optimal allocation (over the longest time frame).
This just about matches with previous studies I have seen, which produce targets between 10% and 40%.
Trend-following has a relatively higher optimal weight in the early period of the sample given its outperformance, and on a relatively lower level of volatility, throughout the dot-com bubble burst and the Global Financial Crisis (GFC), periods where traditional assets struggled. However, following the GFC, trend-following entered what many regard as the ‘CTA winter’, where returns were broadly flat, which leads to a drop in optimal weight.
Drawdown
Investors who are expressly interested in trend-following’s defensiveness may consider drawdown to be the most pertinent measure of optimal.
This bumps up the optimal allocation to 63%.
Tracking error
Next, they look at the annualised tracking error for trend versus global equities.
Trend-following’s convexity means that this tracking error to 60/40 is generally at its greatest when we need it most, in other words, when 60/40 is at its worst. The spikes in the tracking error curves are contemporaneous to drawdowns for 60/40, while the curves taper towards their lows when 60/40 rallies.
The paper doesn’t say this explicitly, but my take is that we needn’t worry about tracking errors.
Implementation
The next section looks at the ease of adding a trend allocation.
The cash efficiency of instruments traded by trend-following strategies means that little additional cash is needed to fund an allocation. Allocating 90% of cash to the LOMA and 10% to trend-following, with the latter levered up by 4x, leads to roughly roughly 40% trend-following, 90% LOMA (or 30% trend-following and 70% LOMA in normalised allocation terms).
An alternative implementation replicates 100% of the LOMA using futures (or swaps) and allocates 40% of the remaining cash to trend.
Solution 2, with the same amount of 60/40 as our original 60/40 portfolio, enhances the return of 60/40 by 2.3% per annum on similar volatility and drawdown.
Conclusions
This is a short and easy-to-read paper that provides ammunition for allocations to trend of between 20% and 63%.
- I’ve never met a UK-based private investor with even a 20% allocation to trend, and given the difficulty of accessing ready-made trend ETFs here in the UK, I don’t expect that to change soon.
DIY trend is time-consuming to implement, so my own approach is to lump TAA strategies (which are simpler to execute) into the same bucket.
- At the time of writing my Trend/TAA allocation is 7.6%, and I should hit 11% or 12% by the end of 2024.
I can see a 15% or 20% allocation in my future, but probably not 63%.
Mike Rawson
Mike is the owner of 7 Circles, and a private investor living in London.
He has been managing his own money for 40 years, with some success.
