Should trend followers lower their horizons?

Not all trend followers had a bad summer. The mainstream funds that track trends over a medium horizon did, it’s true. The median of those firms lost nearly 3% in August, and the worst quartile at least 5%, according to NilssonHedge data. But some of the firms that follow trends over a horizon of hours to days enjoyed one of their best months of the year. It raises the question: should the conventional players change what they’re doing?

Some reckon perhaps these firms should. Markets have changed in ways that today leave legacy models behind, the argument goes.

This question isn’t new. In 2022, investors faced a barrage of shocks that caused historic fluctuations in asset prices, including runaway inflation, war in Ukraine, crypto winter, and rate hikes. These challenges forced systematic investors to consider how best to adapt to fleeting volatility.

In 2020, it was the unprecedented speed of the market’s crash and subsequent recovery during the Covid pandemic that led equity trend strategies to lose nearly 8%.

But experts have noticed a new feature of markets: more extreme shocks over a period of a few days and then a quick recovery. The volatility mini-quake in August was an example.

Katy Kaminski, chief research strategist and portfolio manager at AlphaSimplex, believes short-term signals are better able to capture this phenomenon.

“This has been very common in markets for the last two years, and it may have to do with how quickly markets move, and how fast people readjust positioning compared to before, with systematic trading and others. Once there’s a volatility spike, it corrects itself, as opposed to before, where it had a decay,” she says.

In recent times, the specific factors at play have arguably been central bank policy shifts and confusion about what to make of them, bubbly valuations, geopolitical risks and crowding into popular trades. Some argue that investors have simply learned, since the central-bank-fuelled recovery in March 2020, always to buy the market dip. The mushrooming of strategies and funds that sell volatility, also, has been pinpointed as a cause of a change.

On the face of it, the case for shortening horizons seems compelling. The short-term trend follower Crabel Capital Management made 12% in August. Another firm, Advanced Alpha, was up 12% also. A newish fund from KeyQuant created recently to capture shorter-term trends was up 6%. As a group, short-termers returned an average of about 1% in August, placing them comfortably in the top quartile of performers, according to NilssonHedge.  

Others are less sure, though, and that includes some of the faster-moving trend followers themselves. Firms that trace trends over the medium to long term suffer drawdowns when markets reverse, they acknowledge. But investors shouldn’t allow such episodes to cloud their judgement.

Lisa Martin, director of business development at Crabel, questions whether the data really shows more frequent reversals. Rather, she reckons, investors that entered trend strategies based on the performance of trend since the 2008 financial crisis are experiencing discomfort.

As a result, she says, many trend-following firms have included shorter-term strategies in their portfolios to lessen the severity of drawdowns related to sudden directional market shifts.

“Since the S&P has been on an upward trajectory with a few retracements, trend followers are long stocks. The reality is trend followers will turn long to short if the equity drawdown is severe enough, but there will be a good bit of pain on the way down, and our trend peers are very aware of their positioning, so the addition of more responsive trading concepts can help shore up that weakness,” she says.

And though mainstream trend-following hedge funds suffered during the summer, there was one saving grace.

Months like August are atypical. Arguably, the job of conventional trend followers in a portfolio is to protect against prolonged market slumps, the job of faster moving strategies to guard against reversals. And over the longer term this year, short- and medium-term versions of the strategy delivered similar sorts of returns.