Trend following is an alternative investment that is highly complementary for most investment portfolios. The strategy is now widely available to UK financial advisers, having already been a core allocation for institutional investors around the world for many years. Here we introduce the strategy, before exploring how it works and its role in a portfolio.
Trends Are Everywhere
Trend-following strategies aim to make money from price trends, up or down, in stock markets, government bonds, interest rates, commodities and currencies.
Trends have been a feature of global financial and commodity markets throughout history, with markets rising and falling over multi-year periods. See, for example, UK government bond yields plotted since 1700 below. Trend-following strategies profited from the long-term downtrend in bond yields from the 1980s through to 2020 and have made money from a steady uptrend since the final quarter of 2021.
Trendy Behaviour: 300 Years of UK Government Bond Yields
Sources: Winton, Bloomberg, Bank of England.
The recent uptrend in bond yields has been due to central banks gradually increasing interest rates to counter the return of inflation. Trends can, nonetheless, be caused by anything from geopolitics and investor behaviour to technological innovation and shifts in demographics. Trend-following strategies do not need to understand why a market is trending; instead, they are designed to profit from trends as and when they emerge.
How Does Trend Following Work?
Trend-following strategies seek to profit from the tendency for markets to trend by consistently applying rules-based trading systems to many different markets.
The trading systems are designed to identify the beginning and end of price trends, while sizing positions so that they are proportionate to the strength of the price trend and the riskiness of the market.
The strategy takes both “long” positions (those designed to profit from rising markets) and “short” positions (those designed to profit from falling markets).
Why Invest in Trend Following?
Many of the world’s most sophisticated institutional investors have been investing in trend-following strategies for decades. The primary reason for doing so is that the strategy offers valuable diversification for other investments, particularly traditional stock market and bond holdings. These diversification benefits are more important now than ever, as we explained previously.
There are three key reasons why trend following is so complementary for stocks and bonds:
1. Long and short: Trend-following strategies take long positions in market uptrends and short positions in market downtrends. Traditional stock and bond investments are only able to profit from uptrends in their respective categories.
2. Novel exposures: Trend-following strategies provide exposure not only to global stock markets and bonds, but also currencies and commodities, spanning energies, base metals, precious metals, crops and livestock. There are few other ways UK investors can gain exposure to movements in the price of cocoa, live hogs and nickel in their investment portfolios.
3. Systematic: Trend-following strategies do not attempt to predict what markets will do next. Instead, they follow trading rules that dynamically adjust the portfolio in response to market price movements. This approach can prove especially valuable when markets behave in a way that forecasters and analysts fail to predict.
While the principles of trend following are straightforward, the successful implementation of the strategy is difficult. Experience and a commitment to research and development are critical, as is understanding the nuances associated with operating the strategy.
