The popularity of trend-following strategies has surged over the past decade. In the wake of the 2008-2009 financial crisis, a growing number of investors embraced the risk-management attributes of the so-called momentum factor—the tendency of recent returns to persist in the near-term future. (Trend-following and momentum strategies are close cousins; for convenience, we’ll use these terms interchangeably.)
Backtests found in a deep pool of academic research appears to document the power of momentum’s advantages over a buy-and-hold strategy or periodic rebalancing to target weights. But for some momentum strategies, results in recent years haven’t lived up to the backtests.
As one example, consider how a popular momentum strategy fares via a large-cap U.S. equity fund that’s focused on the strategy. The iShares Edge MSCI USA Momentum Factor ETF (MTUM) has earned a 15.1% annualized total return over the past five years (through Jan. 14, 2020), according to Morningstar.com. That’s a solid return, but the results appear to reflect a hefty dose of standard growth-equity beta, or so one might reason after looking at the 15.5% annualized gain in iShares Russell 1000 Growth (IWF). Although MTUM uses a momentum screen, its portfolio has a large-cap-growth bias and so it’s debatable how much of the momentum factor is adding to results over and above the growth factor.
A longer-run view of trend-following indicates a mostly flat performance for the past five years or so, based on Societe Generale’s SG Trend Index, a benchmark for strategies in this corner. By contrast, U.S. stocks overall (S&P 500 Index) have remained in a bull market.
Researchers at AQR Capital Management recently performed a deep dive in search of an explanation for what’s going wrong– and what wasn’t — with these strategies in recent history.The good news, according to “You Can’t Always Trend When You Want,” is that recent headwinds in the trend-following corner aren’t due to a fundamental breakdown in the factor’s ability to generate results.
“Our results show that lower performance for trend following in the current decade is almost entirely explained by a lack of large risk-adjusted market moves (positive or negative),” the paper’s authors conclude.
By contrast, two other possibilities don’t appear to be explanatory factors. “We do not find evidence of a material change in trend-following strategies’ ability to translate market moves into trend-following performance, nor do we find evidence that trend followers have been less diversified.”
As an illustration of how the size of market moves correlate with trend-following performance, the paper presents simulated results for trading strategies in this niche vs. the magnitude of market changes. As shown the following exhibit from the paper, there’s a clear positive correlation between trend-following performance and the size of market moves, based on hypothetical data for the past 130 years. Notably, the simulations for the past decade (2010-2018) show that the lower performance numbers are linked to lower absolute market moves (indicated by the gold diamond markers).
The question everyone is asking, of course, is what awaits trend-following strategies in the years ahead? The paper offers a degree of optimism by suggesting that the recent lull may be temporary. Using the historical simulations as a guide, the authors speculate that “trend-following strategies should be able to deliver performance more in line with full sample results going forward if the size of market moves reverts to levels more consistent with the long-term historical distribution of returns.”
Then again, it’s entirely possible that a structural change in the market has occurred — one which suggests that large market moves will be less frequent than in the past. After all, history doesn’t always repeat, although sometimes it rhymes.
 Dissecting momentum’s attributes (or the lack thereof) is more than an academic curiosity for AQR, which is a quantitative-based money manager that uses several flavors of momentum and trend-following applications.
By James Picerno, Director of Analytics
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