What the heck is "managed futures trend following" and why should I care?

A primer on an often forgotten but powerful investing strategy

Introduction

What do you think when you hear the words “investing strategy”? Perhaps something about ETFs, index investing, Nvidia, NASDAQ, and maybe even Warren Buffett who brought ‘value investing’ into the public lexicon? These are all valid and important concepts, but, as I’ve discovered over the past few years, just the tip of the iceberg of the investing world.

The stock market is generally considered to be ‘efficient’¹ - meaning that all known information is priced in. In other words, it should not be possible to achieve higher risk-adjusted returns than the market over the long term. But if that’s the case, how is it that super investors like Buffett, Druckenmiller, and Peter Lynch have all beaten the market by wide margins over decades? Is it even worth it to go beyond basic index investing which has returned about 9-10% annualized returns for the past 100 years?

Over the past 2-3 decades, academics have been exploring various factors which help to explain why some types of stocks do better than others. These effects are often referred to ‘anomalies’ because, according to the Efficient Markets Hypothesis (EMH), they shouldn’t exist! The most well known one is the value factor, which measures the relative performance between cheap stocks vs expensive stocks. Over the long term, cheap stocks have generally outperformed expensive stocks and returned a premium over the market returns. This makes sense, because cheap stocks tend to be lower quality and therefore higher risk. If you buy them, you are taking on extra risk and should expect to be compensated for it. Risk-based explanations for why certain stocks do better than others are nice and intuitive.

However, we also know that one of the strongest factors historically is the momentum factor. The momentum factor is dead simple - you buy the stocks that have gone up the most, and short the stocks that have gone down the most. Basically, you buy the biggest winners, and sell worst losers, expecting that the prevailing trends will continue. The crazy thing is, the momentum factor has been one of the strongest, leading Prof. Eugene Fama, the father of efficient markets, to remark that it is the ‘premier anomaly’.² The empirical evidence is hard to deny, but why does it exist? Why should investors expect to earn a premium by buying stuff that is up the most, and shorting stuff that is down the most? Where’s the risk in that? No one has a bullet proof explanation for why this anomaly should exist. The best I’ve heard is that the momentum effect is the result of human behavioral biases to initially underreact to news, then overreact.

History of trend following

Trend following is closely related to momentum. A trend is simply a time series where prices are moving up or down over some period. Therefore, trends can be either positive or negative. This is not a new concept. Gary Antonacci mentioned in his excellent book “Dual Momentum”, that trend following was mentioned in the 1920s in a book on how to trade markets.

The investment firm AQR published 2 papers in 2014 and 2019 entitled “A century of evidence on trend following”³ and “Trend everywhere”⁴ respectively. You can probably guess what they found! Exploitable trends have existed everywhere, across markets and geographies, for the past 100+ years. Greyserman and Kaminski went all the way back to the 13th century, showing that a simple multi-asset trend following strategy would have returned 13% annualized over 800 years!⁵

800 years of trend following | https://thehedgefundjournal.com/trend-following-with-managed-futures/

How can something so simple still make money?

On the surface, this strategy seems wayyy too simple to actually work with positive expectancy. Seriously, how could simply going long and short trends generate profits over the long term, with even higher potential profits than a buy and hold strategy? I would say 3 things: First, it doesn’t make money all the time. Trend following any individual asset has a low Sharpe ratio typically around 0.1-0.2. And even when you combine a bunch of assets together, trend following funds can have prolonged multi-year drawdowns that test your resolve (“No pain, no premium”). The second point is that diversified multi-asset trend following primarily profits from some combination of risk premia and investor behavior like underreaction and overreaction. However, it is pretty crucial that a trend following strategy has exposure to a wide variety of markets to capitalize on trends wherever they show up. Third, it may seem simple on the surface, but actually implementing such a strategy requires carefully making design choices related to risk management, trend measurement, execution efficiency, and market selection.

Isn’t this just performance chasing?

Ask most people about investing and Warren Buffett is the first thing that comes to mind. “Buy low, sell high” is the mantra, not “buy high, sell higher” or “sell low, buy back lower”. To some extent, yes this is performance chasing. But it is done in a highly diversified, systematic, emotionless, and disciplined way. It is not about chasing the latest meme stock. In fact, systematic trend followers are often quite early to new themes that capture the public attention. A trade that worked explosively well in 2024 was cocoa:

Nearly a 5x run from long run average to the peak in 2024 - now that’s a trend! Chart from: https://tradingeconomics.com/commodity/cocoa

It only showed up on CNBC after it was already up 400%, but trend followers had been in it many months earlier and many were already trimming exposure at it ran to its peak.

Why should investors care and how to evaluate trend following strategies?

This the part you probably care about the most - why should investors care? The short answer is that adding managed futures trend following to your portfolio could greatly improve the overall risk adjusted returns, while reducing the big drawdowns. Why does it do this? Because a trend following strategy bets on a nascent trend continuing, but if it doesn’t, it will exit the position for a small loss. Even though only about 40% of trend following trades are profitable (win rate) on average, the big winners more than make up for the numerous small losers. In essence, the strategy cuts off the left tail of big losers, while allowing upside participation in the big winners, whenever and wherever they eventually show up. In addition, trend following is “long, long term volatility” - in other words, it performs best in highly volatile times for stocks, providing an important uncorrelated return stream. It’s important to judge the performance of this strategy in a portfolio context, not only as a standalone strategy.

Please see my article linked below for information about how it can be used in a portfolio:

How investors can add trend following to their portfolio

Conclusion

In conclusion, I think more retail investors should at least consider the benefits of managed futures trend following in their investing journey. It’s a strategy that struggled through the anomalously low volatility and low interest rate period of the 2010s, but should do materially better in the higher volatility, higher interest rate period we are in now. Be on the lookout for more to come on this topic, including reviews of my favorite trend following products and funds!

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1. This idea is captured in the Nobel prize winning work of Fama and French termed the “Efficient Markets Hypothesis” (EMH)

2. https://www.nasdaq.com/articles/momentum-demystified-2017-05-09

3. https://www.trendfollowing.com/whitepaper/Century_Evidence_Trend_Following.pdf

4. https://www.aqr.com/Insights/Research/Working-Paper/Trends-Everywhere

5. https://thehedgefundjournal.com/trend-following-with-managed-futures/