The Trend Following Disappointment 

Published by Bob Elliott on on Jan 30, 2023 5:03:06 PM

Interest in trend-following strategies had a resurgence last summer as both bonds and stocks fell and many trend followers did pretty well. In the span of just 6 months, the assets under management (“AUM”) in the combination of ETFs and Mutual Funds with these strategies doubled from 10bln to 20bln as investors piled in as these strategies returned 30%+ in the first 9 months of 2022.

At the time, we cautioned investors from adding concentrated positions in trend strategies. While it had been a good start to the year, past evidence suggested that these strategies often underperformed a more diversified portfolio of alpha strategies following periods of outperformance. Unfortunately, that is exactly what happened. On an AUM-weighted basis, these strategies are down approximately -15% from daily peak. At the same time, diversified hedge fund strategies (which include a small sleeve to these trend-following strategies) have delivered roughly 6% positive returns.

For ETF investors, it’s been particularly difficult. The 10x surge in AUM and then subsequent losses means that, while these ETFs have returned a bit over 10% gains since the start of 2022, on an AUM-weighted basis investors experienced returns of -15%. That is quite a disappointment.

Flows surged into a wide range of trend-following strategy mutual funds and ETFs following the strong performance in the first few months of 2022 and gained further steam as trend-following strategies outperformed stocks and bonds through September. What that also meant was that many of the new investors in these funds have seen either flat or negative returns on their holdings.

The surge of interest in trend-following ETFs was particularly strong with AUM in these products 10x-ing at the peak during the year. The experience of ETF investors also highlights the risk of performance chasing. Most of the flows came into these funds following a period of strong performance. When performance reversed, new investors incurred substantial losses.  Despite the fact that these funds have delivered just over 10% cumulative returns over the last year, the AUM-weighted return for investors has been -15%.

Mutual funds did not experience quite as bad a performance-chasing drag because many of these funds also had substantial assets entering this year. But that doesn’t mean these funds are immune from challenges. Unlike ETFs, which use tax-efficient structuring to minimize taxable distribution, trend-following strategy mutual funds issued substantial taxable distributions at the end of 2022.

The table below shows the sizable dividend and capital gains distributions done by the largest trend-following mutual funds. On an AUM-weighted basis, dividend disbursements were 8% for the year and capital gains distributions were also 8%, the vast majority of which was short-term.  So while these funds were able to put up performance numbers between 20-30%, investors will also incur a substantial tax bill this year whether or not they continued to hold the investment.

Finally, one of the challenges in investing in a trend-following manager is the substantial dispersion of returns that exists among these products. While most funds did pretty well since the start of 2022, some were up as high as 45%, while others were down as much as -10%. Given the nature of these strategies – systematically defined to trade markets based on specific price movements – it’s also very hard to differentiate between fund manager styles to determine skill. While one set of trend approaches may have outperformed this year, it is by no means certain that those particular trend approaches will do the same in the future.

The surge of interest in trend-following strategies is another in a series of examples of how return-chasing alpha strategies can often lead to significant disappointment for investors.  Most investors are much better off allocating to a diversified portfolio of alpha strategies since predicting which type of manager or fund style will outperform in the future is very difficult.

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