Sunday, August 17, 2014

Is return chasing the same as trend-following?

Recent St Louis Fed study, The Cost of Chasing Returns, suggests that investors are mainly return chasers and this behavior is bad for their financial health. The author looks at the correlation between past mutual fund performacne and mutual fund flows which is positive. Chasing these returns is bad for investor health and does worse than a buy and hold strategy over rolling 7-year periods. The return chasing is the time weighted returns based on the flows into the fund.The drag of following past performance as measured by the author looks to be significant. The buy and hold investor adds to positions in equal portions each period without any market view. Mutual fund investors buy at tops and increase on more strength.

There is a current meme that trend-following as a strategy is bad because of the extrapolative behavior of investors. Unfortunately, there is a failure to think through the behavior of systematic trend-following versus looking at investor expectations through flows and their return result when plotted against market moves. Trend-following will buy rising markets, but will cut or reverse exposures upon reversal. This behavior is usually faster than the three quarter correlation showed by the author. Additionally, trend-following will use risk management to control exposure and cut loses. This does not occur with mutual fund return chasers.

Yes, performance chasing with the crowds of mutual fund investors is bad, but that is not the same as saying following trends is a bad strategy.

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