How investors can add trend following to their portfolio
3 ways to add 'the best equity diversifier' to your portfolio
Legendary natural resource investor Rick Rule recently called US government bonds an investment that offers ‘return-free risk’ - an allusion to the massive drawdowns long-duration US Treasuries experienced in 2022, and expected poor returns going forward due to fiscal dominance and rapidly growing debt financed by Treasury issuance.
Despite this, the vast majority of investors regard the famous ‘60/40’ portfolio as the gold standard despite the fact that no one can explain where this idea came from. The logic behind it is that equities are the main driver of returns, while bonds reduce the volatility of the portfolio and protect against drawdowns. Seems logical until one examines the relative volatilities of the two asset classes - despite constituting 40% of the portfolio value, bonds contribute only 20% of the volatility. Therefore, the portfolio’s movements are still dominated by the volatility of equities. If you really wanted to maximize risk adjusted returns, the portfolio would need to be closer to 20% equities and 80% bonds! (Side note: Strategies such as Hedgefundie’s Excellent Adventure lever up a 40/60 stock/bond portfolio using 3x levered ETFs to achieve improved risk-adjusted and absolute returns - I’ll cover the pros and cons of this strategy in another article.)
Obviously most people don’t want to be in 20% equities, 80% bonds because of the poor expected returns vs 100% equities. They are willing to hold the 60/40 portfolio to achieve better returns, but the true risk of this strategy is actually greater than most investors realize. This portfolio implicitly depends on low/negative correlations between equities and bonds (note that equities and bonds have been positively correlated over most of the last 100 years), so that bonds go up when equities crash. It is further helped by secularly falling bond yields which occurred from 1982-2020 but perhaps no longer. Now, with yields at the short end above 5%, the 60/40 portfolio certainly isn’t dead, but could we do better?
The case for trend following
Trend following to many sounds like momentum chasing or ‘momo’ investing. However, this is not necessarily a bad thing. Analysis of Fama-French data shows that US high momentum stocks (top decile) have returned north of 15% CAGR gross of fees since 1945. Commodity Trading Advisors (CTAs) are essentially hedge funds that trade systematic strategies such as trend following, carry, and other more exotic approaches. Trend following is exactly what it sounds like - if a particular asset is ‘trending’ whether up or down, the strategy will take a long or short position until the trend weakens or reverses. It’s simple in concept, but complex in execution as such traders need to make carefully choose and implement the right lookback periods, risk management techniques, and execution costs/methods.
Eric Crittenden, CIO of Standpoint Funds, called trend following “the best diversifier for equities”. The data (Fig. 1) certainly seem to back that up:
Fig 1: Comparing a 60/40 stock-managed futures (trend following) portfolio vs 60/40 stock-bond portfolio from 2010-2024. Assets used for comparison: VFINX, AQMNX, VBMFX. Tool: Portfolio Visualizer.
Note that the comparison in Fig 1 is between 60/40 US stocks-managed futures vs 60/40 US stocks-bonds from 2010-2020. This period of time was one of the all-time bests for US equities, and one of the worst for managed futures. And yet, the stocks-managed futures combo came out slightly ahead! While this is a short data set of only 10 years (perhaps an eternity these days!), there are several trend following funds that have existed since the 80s. A good example is Dunn Capital, whose flagship World Monetary and Agriculture (WMA) program has returned 13% CAGR net of fees(!) since 1984.
So how does one add trend following to their portfolio? The good news is, thanks to SEC rule changes allowing for the use of derivatives in ETFs, there are now more options than ever for retail investors to get exposure to this venerable strategy.
Option 1: Buy trend ETFs or mutual funds
ETF Examples: KMLM, DBMF, AHLT
Mutual fund examples: QMHIX, ASFYX, AHLYX
Pros: Widely accessible, fees vary widely but many are quite reasonable
Cons: 40-Act regulations limit the volatility of these instruments - the highest is typically around 15% annualized vol.
Use case: This is the simplest and most direct way to add trend following to your portfolio. There are a number of very good ETFs and mutual funds that implement trend strategies. But to be honest, this is my least favorite way to allocate to trend because you have to sell stocks/bonds to buy these which means that there’s a pretty high performance hurdle for the trend part of your portfolio to make that exchange ‘worth it’. And due to the limited vol of these funds, they don’t provide much offsetting vol/convexity to ballast your stock and bond heavy portfolio unless you give it a large allocation (at least 30-40%). If the other options are not available though, this is a decent approach. At least 10-15% allocation is needed to move the needle.
Option 2: Leveraged / stacked products
ETF Examples: RSST, RSBT
Mutual fund examples: BLNDX, RDMIX, MAFIX
Pros: Widely accessible, reasonable fees, provide capital efficient exposure to managed futures/trend
Cons: If the trend portion is a replicator strategy, you are exchanging single manager risk for model specification and lag risk
Use case: This is my favorite way to get managed futures/trend exposure if one’s net worth is below the minimum required for private investments like those described in Options 3 and 4. Every $1 invested in one of these products gives you more than $1 of total nominal exposure to various assets. As an example, RSST gives 100% exposure to US equities + 100% exposure to a managed futures trend strategy. Mutual funds tend to be more diversified in terms of the range of futures products traded (e.g. BLNDX trades 50+ markets while RSST aims to replicate the SocGen CTA index and trades 27 markets).
Option 3: Private pooled investments
Examples: Dunn WMA program, Mulvaney Capital, Mutiny Funds Cockroach Portfolio
Pros: Access to capital efficient and high volatility (25-30%+) strategies
Cons: High fees (e.g. Dunn WMA charges a 25% performance fee), high minimums, accredited/qualified investor status
Use case: If one qualifies for accredited investor status, it is worth looking at private hedge fund trend strategies such as those offered by Dunn, Mulvaney, or Mutiny. Minimums vary but are usually at least $20-100k. The main advantage of these private funds over public ETFs/MFs is that they can run at much higher volatility (25-30%+) and therefore offer higher long term returns despite the fee structure. As an example, Dunn has returned 13% CAGR since 1984 net of fees! In addition to pure trend funds, Mutiny offers an interesting strategy called the “Cockroach Portfolio”. It offers leveraged/stacked allocations to stocks, bonds, long volatility/tail hedging strategies, and trend following for nominal ~200% exposure with a 1 and 10 fee structure. A solid ‘all weather’ portfolio.
Option 4: SMA
Examples: Alpha Architect SMA, AQR SMA
Pros: Most efficient and customizable way to overlay trend on an existing portfolio.
Cons: Very high barrier to entry (typically $5mm minimum net worth)
Use case: Investors who can meet the minimum net worth may find an SMA the best option for their portfolio. You can own a custom set of tax efficient ETFs, and use them as collateral for a trend trading strategy overlay. This provides capital efficient exposure to trend while owning a customizable set of assets. Furthermore, the trend strategy can be run at a higher vol than 40-Act instruments further adding to the potential returns and volatility. There is also scope here for tax alpha.
Risks
To be clear, even though trend following is a powerful strategy with a long history of success, none of the strategies here are ‘low risk’. Especially when using leverage, you are explicitly introducing risk. The concept of using leverage to gain exposure to multiple asset classes or strategies isn’t new - funds like PSLDX have offered a 100/100 stock/bond strategy since 2007 to institutional clients termed as ‘portable alpha’.
Common objections
“The performance of managed futures sucks!”
Response: While true that managed futures funds have gone through stretches of underperformance and drawdowns, the same can be said of equities or any other liquid strategy if you look back far enough. The important point here is to consider how managed futures is accretive to a portfolio - does it improve the risk adjusted returns of the overall portfolio when you add it in? Over the long term, the answer has been yes. Looking at the returns of the SocGen CTA index in isolation may look anemic by itself, but consider that the biggest moves up tended to occur when equities went into a bear market.
“It’s tax inefficient!”
Response: Yes introducing futures-based strategies can be more tax inefficient than buying and holding tax efficient equity ETFs. There is no way around this except for running the strategy in a tax-sheltered vehicle like an IRA, or getting some tax alpha through an SMA. Historically though, the returns have more than compensated for fees and tax drag. Note that ETFs offer no tax advantage over mutual funds when futures are traded within the wrapper.
“Managed futures went nowhere during the 2010s!”
Response: This is true, but it’s important to compare the returns of managed futures to the right benchmark. Comparing to equities makes no sense. Rather you have to look at the returns of managed futures strategies vs cash as it is an explicit cash-plus strategy (since it holds cash/T-bills as collateral for futures positions). From that perspective, if the worst managed futures has done is slightly beat cash (which yielded close to 0%) throughout the 2010s, that’s pretty darn good! Think about the worst periods for equities or bonds - they have been far, far worse than that! That said, the S&P500 beat pretty much everything during the 2010s (except the NASDAQ that is). So while I concede that selling stocks to make an allocation to managed futures would’ve reduced returns significantly during that decade, stacking the exposures like RSST does would’ve worked far better (see Fig 3), illustrating the importance of leverage/capital efficiency. I’d also ask: how likely is the S&P500 to repeat that performance? I’d say odds are against.
Fig 2: Performance of AQR’s managed futures fund AQMNX from 2010-2020.
Fig 3: Comparing a 100% equities portfolio vs 60/40 equities/managed futures vs 100/100 ‘stacked’ equities and managed futures.
“Which managed futures fund do I choose? They all have different return profiles!”
Response: This is a legitimate criticism of managed futures strategies - there is so much dispersion between managers/funds that you never know if you’re picking the right one or the wrong one. A good approach is to either A) hold a replicator strategy like that offered by RSST or DBMF, or B) hold a set of several funds to diversify the manager risk. That said, it is hard to see a program like Dunn WMA with 40 years of live performance history disappointing for the next 20 years. So if an investor is going to pick 1 fund, it’s probably best to pick one with a very long track record, transparent risk management approach, and reasonable non-hyperbolic communications.
Summary
The classic stock-bond portfolio tends to do well when inflation is low and stable, and correlations between stocks and bonds are negative. However, this approach has implicit risks for investors when those conditions are not satisfied. Trend following adds a third dimension to portfolios to potentially protect against inflationary episodes and positive stock-bond correlations. Trend following has historically had low/zero correlation to stocks and bonds due to its ability go to both long and short across the 4 major asset classes (equities, rates, currencies, and commodities). Investors today have many more options at reasonable fees to add exposure to this diversifier and reduce the fragility of their portfolios. This article outlines some options investors can consider.