Against one of the most challenging economic backdrops in several decades, trend following strategies delivered substantial profits to their investors last year, for the most part. Unsurprisingly, this has generated a rising tide of interest from a new cohort of investors — many of whom started their careers post the Global Financial Crisis (GFC) of 2008.

While Trend is currently “trendy”, the time-tested strategy has ably navigated a multitude of economic environments over the last five decades. The post-GFC, pre-pandemic, QE-dominated 2010-2018 period has been the outlier in offering fewer opportunities. Regardless of performance, the key properties endure, cementing Trend as: adaptive (can handle a wide range of economic scenarios), agile (as markets change, its positions change) and resilient (won’t double-down on losing positions).

The lost decade: QE’s chilling effect

The application of trend following as a strategy has a long history, stretching back to the late 1940s when Richard Donchian established Futures, Inc., which employed a trend following strategy. Several trend managers that started their track records back in the 1970s remain, highlighting the longevity of the CTA industry.

In Figure 1, we highlight a selection of major macro-economic or geopolitical events that defined the various decades. From the oil crises and stagflation of the 1970s, to the savings and loans crisis of the 1980s, the collapse of the USSR, the bursting of the Japanese bubble, the Asian and the Russian crises of the 1990s, to the accounting scandals, the Tech Wreck and the Global Financial Crisis of the 2000s — Trend has demonstrated its adaptability and suitability to navigate myriad challenging economic environments.

Looking at the pandemic and post-pandemic inflationary, deglobalizing, geopolitically charged era so far in the 2020s, Trend has also ably managed to navigate this environment.

This leaves the 2010s as an anomalous period in global markets where the most significant and enduring economic theme was that of large-scale and globally coordinated quantitative easing (QE) and extremely low to negative interest rates in major economies referred to as ZIRP (zero interest rate policy). The chilling effect of the artificial suppression of risk during the QE/ZIRP period resulted in rather muted performance from divergent macro strategies, dubbed retrospectively as the “CTA Winter.”

Without needing to make any specific forecast for the next decade (other than assuming that we will not go back to widespread QE and ZIRP), the message from history feels clear. The general adaptability of trend following across numerous different environments through the decades suggests the outlook for Trend could indeed be favorable.

Down the escalator – up the elevator

An underappreciated property of trend strategies is that of potentially transforming negatively skewed return distributions of traditional assets into positively skewed ones.  

Negative skewness implies that the majority of the returns are a bit above average but that the outsized returns tend to be significantly below average. A good visual analogy that helps here is to imagine being able to “walk the return path” — negative skewness implies traveling steadily up the escalator and then going quickly down the elevator, whereas positive skewness is akin to traveling down the escalator but up the elevator.

What we observe when we look at return data is that traditional asset class returns are negatively skewed over all time periods, whether we measure on a daily, monthly or quarterly basis. In other words, despite the most common return being positive, the larger returns tend to be surprises or shocks to the downside. When it comes to trend-following strategies, the investment process is such that over longer time horizons, it transforms negatively skewed distributions into positive ones through adaptive and dynamic positioning.

It is worth emphasizing why positive skewness is such a desirable property in a strategy. Provided the strategy has a positive expected return then having positive skewness implies that the maximum expected upside is larger than the maximum expected downside. Conceptually, this conforms to the adage: “Run your winners and cut your losers.” From a risk management point of view this type of strategy profile is also desirable as the likelihood of outsized returns will tend to be on the upside rather than the downside.

However, from a behavioral aspect, living with a positively skewed return profile presents a challenge. Having a higher proportion of returns below average means that at some point doubt may creep in — thus a long-term holding horizon is paramount to be able to extract the benefits of positively skewed strategies. 

Trend following is an adaptive, agile, and resilient strategy with an inherently positively skewed return profile. The outlook is favorable and robust across a multitude of economic scenarios including more muted but still diversifying returns during the years dominated by QE and (near) zero interest rate policies. However, the likelihood of the next decade being a return to the QE/ZIRP era seems remote as inflation, deglobalization, decarbonization, energy scarcity and significant geopolitical stress all tend to point towards a more dynamic market environment — one that potentially favors both the adaptability and the resiliency of Trend.