Trend-following seems generate positive returns across all market sectors and over long time periods. There may be stronger and weaker periods of performance, but the long-term historical record is trend favorable. However, there is some conflicting evidence with how successful trend-following is measured and structured. Not all trend-following is alike, or more importantly the historical success is partially an artifact with how the tests are conducted.
Care has to be applied with determining how to best form a times series momentum or trend program. For example, the exhaustive study "Time Series Momentum" by Moskowitz, Ooi, and Pedersen found positive value from trend-following when structured with volatility scaling. A subsequent paper "Time Series Momentum and Volatility Scaling" by Kim, Tse, and Wald analyzed similar data and found that trend-following is no better than buy and hold when there is no volatility scaling. Their criteria for trend-following success is the measurement of alpha from a multi-factor enhanced Fama-French-Carhart model and a comparison with buy and hold alpha for a wide variety of markets versus a multi-factor model. This is not the same as saying that trend-following generates positive returns.
How risk is managed matters, and the use of leverage is critical with futures trading. Not using the leverage in futures diminishes performance and alpha potential. The figures below show relative performance between scaled and unscaled alpha versus a buy and hold position. This research also finds that when buy and hold also scales volatility the gains from time series momentum is diminished, and the performance of cross-sectional strategies while positive will show differences in relative performance when there is volatility scaling.
This has been an ongoing issue for discussion with trend-following managers. Do you volatility scale or not? Use risk parity or not? I see both sides of this argument and have been of the view that sizing based on volatility is useful but if overdone it can conflict with the goals desired by a trend model.
Not surprising, the value-added for investors is in the details of how risk is managed, markets are bundled, and leverage effectively used. Investors should pay a premium for portfolio management expertise. The discovery of trends is critical but the true differentiator among trend-following firms is the management of risk.
The ultimate goal of trend-following is to provide positive convexity versus a target benchmark. Convexity gains are focused during periods of market dislocation and not as obvious during long periods of return analysis attempting to measure alpha. Risk adjustments that diminish portfolio convexity harm this core goal, yet volatility scaling will improve overall portfolio characteristics in the long-run.
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