In a more rational world, investors would buy and hold for the long term, because they understand that long-term returns require long-term investment. Markets would behave rationally and according to the Efficient Markets Theory: prices would reflect all available information, making it impossible to consistently purchase undervalued stocks and sell inflated ones. Assets destined to decline in price would do so inadvertently.
The reality, of course, is quite different. Human judgement is fallible and based on a broad set of both rational and less-rational factors. Our financial survival instinct can make it difficult to stick with an investment strategy when market conditions or our financial situation change. And we often react to market conditions with fear or greed when a more measured approach is called for. Behavioural finance takes that into account and highlights that investors can act contrary to their own interest.
Navigating the interaction between risk and return in financial markets and behavioural economic theory is a challenge for all investors, including and especially superannuation trustees. Investors close to retirement or already retired worry about investment decisions in part because they have a limited capacity to recoup losses. As they see their wealth decline, their tolerance for risk tends to decrease. This makes them less likely to stick to an investment strategy at a time when sticking to a rational investment strategy is most important.
Markets are not static, humans not always rational – what should our response be?
The Adaptive Markets Hypothesis (AMH) exists at the intersection of the Efficient Markets Theory and behavioural finance. The AMH recognises that financial markets are neither always efficient nor always irrational, but they are highly competitive and adaptive. As a result, market conditions are ever-changing; market volatility, risk premia, and cross-asset correlations are not static. The implication is that investment strategies must continuously adapt as markets evolve in order to deliver more consistent performance.
Dynamic markets can create opportunities for investors willing to manage portfolio risk by actively adapting their market exposures. One central tenet of portfolio theory is that investors can diversify their portfolios by reducing the correlation between the returns from different asset classes or different strategies in their portfolio. However, what is less well understood is a phenomenon observed throughout history: that correlations between asset classes are not static. One example of this was the global financial crisis (GFC). When the crisis hit, assets previously believed to be uncorrelated began to move in lockstep, exacerbating portfolio losses at the worst possible time. The same was true during the 2013 equity rally.
The reality is that risk premia, market volatility, and cross-asset correlations vary over time. This means that any single strategy’s effectiveness will also vary over time. The challenge for investors is not to attempt to predict when correlations will change, or what the future holds for any asset class. The challenge is to come up with an investment process that can dynamically adjust as markets themselves adjust.
Trend following – an overview
Trend following or momentum strategies are managed futures strategies that seek to identify price trends in futures and forward markets including equities, fixed income, currencies, and commodities. These strategies may be capable of providing diversification and mitigating portfolio risk.
Trend following strategies have the flexibility to go long or short in any given asset class depending on the direction of the markets. This provides the potential to profit even when traditional asset classes are falling.
Using a systematic approach supported by extensive research and driven by the view that systematically capturing market trends may have a long-term portfolio benefit. Building this strategy with an eye to diversification of approach (using multiple models, time frames, and assets) and with a focus on volatility management, can help investors manage their potential outcomes. This strategy is also adaptive, so it can nimbly respond to evolving market conditions. It’s also important to note that at any point in time these strategies can outperform or underperform. Therefore it is important to be broadly diversified in our definition of trends, to add value by systematic security selection, and to adapt our time horizon to capture both long and short trends.
Why does trend-following work?
No one knows exactly why markets trend, but history suggests both that markets do trend and that human behaviour can affect those trends. The goal for any trend follower is to identify price trends as they happen. Trend following, not surprisingly, works best when the market exhibits strong trends—either up or down.
Trend following strategies are not an easy ride. Like any strategy, they can underperform as well as outperform, and they have had a challenging time over the past five years. The reasons for this include low volatility, geopolitical uncertainty, and few sustained market trends. But trend following can provide important diversification for an investor’s portfolio.
In general, one idea to take away regarding trend following strategies is that they are an important part of a durable, diversified portfolio that may make it easier for investors to stay invested over the long term.
Is there an optimal allocation to trend following strategies?
A well-structured portfolio should have a mix of strategies that exhibit low or even negative correlations. Many investors typically have significant exposure to long equity positions. The more exposure a strategy has to equity, the more those investors are in danger if markets see another event like the 2008 financial crisis. Adding a strategy like trend following may help investors adapt to changing market volatility and manage their risk. It’s important to allocate enough to make a difference, though every portfolio and every investor has different needs and risk tolerances. We often see allocations of between 5 and 15 per cent of a portfolio.
Strategies ready-made for Australian super funds
Australia’s compulsory superannuation system means that flows into investment funds are large and growing. However, the Australian market is relatively small with limited opportunities. The population is ageing, and interest rates are likely to be lower for longer, so finding ways to manage volatility and mitigate risk, particularly in the pension phase, remains a challenge for trustees of superannuation funds.
It’s no surprise then that super funds are increasingly interested in the plethora of liquid alternatives now available. This includes trend following strategies, which can play an important role in managing risk and improving portfolio diversification.