Register For Our Mailing List

Register to receive our free weekly newsletter including editorials.

Home / 531

What is trend following and why do it?

At its core, trend-following is an investment strategy that seeks to profit from markets that are showing price trends in any given direction. If prices are trending upwards, trend-following strategies will go long the market; if they are trending downwards, trend-following strategies will go short. The mechanics are a little more complicated and making a success of it comes down to things like which markets you trade, how you size your positions and how you control your risk. But that is the basic premise.

Trend-following strategies – also commonly referred to as ‘momentum,’ ‘managed futures,’ and ‘CTA’ strategies – have been employed for decades. While some of the assumptions that are self-evident in classical economics suggest trends cannot exist because markets are perfectly efficient and information is instantly reflected in prices (the efficient market hypothesis which was popular with academics in the ‘70s and ‘80s), the evidence clearly shows that this is not the case. Information is not instantly reflected in prices, people aren’t entirely rational, trends do exist, and an edge can be gained.

Indeed, even in ancient Sumer, the cradle of civilisation, we see evidence of price trends. The discovery of a stone tablet from 5000 years ago recorded corn-prices over several years, and if you look at the time series of those corn prices you can clearly see that they exhibited strong trends.

There are many reasons why markets aren’t perfectly efficient and have a tendency to trend in a particular direction. Macro regime changes are one. For example, the shift to an inflationary regime and rising rate environment over the past year and a half had a ripple effect across markets, and it took time for market participants to digest that information and its wider implications. There's an initial under-reaction and then you see trending type behaviour as markets fully reflect the news. Regime changes can also take several years to play out, as we have seen with sustained inflationary pressure and central bank reactions, or the period of quantitative easing (QE) that preceded it.

Another reason is that investing decisions are made by humans and humans are emotional beings subject to behavioural biases. The pioneering work of Nobel prize winners Amos Tversky and Daniel Kahneman showed that people often act irrationally and harbour a range of cognitive biases that influence their thinking.

For instance, they showed that we suffer from ‘anchoring bias,’ where we give a disproportionate amount of weight to the first piece of information received when thinking through a problem or planning a decision. Investors also have a ‘loss aversion bias,’ generally feeling the pain from losses twice as much as the pleasure from gains, and a propensity for ‘herding’ behaviour.

These phenomena lead to things like panic selling and panic buying and enable stock prices to deviate remarkably from their expected fair values at any given time. Panics, bubbles, booms, and busts, like the dot com bubble or Black Monday, arise as a consequence and create price trends.

The mechanics

There are numerous approaches that can be employed to identify trends and build trend-following models. The core building blocks tend to include ‘moving-average crossover models’ and ‘break-out signals’. When it looks like a price trend is developing because, for example, a shorter-term moving average has broken out of a certain range, the model will generate a signal to adjust allocations.

Trend-following strategies can trade a variety of different markets, including stocks, credit, fixed income, commodities, and currencies. In fact, usually the more markets they trade the better. Trends develop in different markets at different times, and the strategy is designed to adjust its allocations to where trends and price action are happening. The more markets that can be accessed, the higher the chance of finding trends to profit from. To enable them to be nimble, they invest in highly liquid securities like futures contracts and other derivatives.

Trends can develop over a variety of time horizons, whether slower trends that manifest over a few months or faster trends that happen over a few weeks or days. The best trend-following strategies generally combine faster trend following models with slower ones – faster models can react faster to sudden price changes and are more positively skewed, while slower models tend to have a better Sharpe ratio (or risk-adjusted return) but are more negatively skewed.

A systematic approach

Most trend-following strategies take a systematic approach, using coded algorithms for the entire investment process – from cleaning and ingesting data to identifying signals, deciding which trades will be profitable and how to size trades, and executing those trades. This enables them to invest in a disciplined, consistent way, devoid of emotion and according to the principles and rigorous methods that have been pre-determined by the algorithms.

One obvious advantage of this is that it means the strategy can achieve scale. Markets can be traded 24/7 because the entire investment process is automated, enabling access to a much larger pool of markets around the globe and by extension, greater diversification (the only ‘free lunch’ in the investment world).

It also removes human emotion and cognitive bias from the investment decision-making process, avoiding situations where discretionary investors may exit a trade too early because of fear, for example, and not capitalising on an enduring trend. The strategy also always stays on course – whether maintaining set correlation levels between securities to ensure diversification or scaling the portfolio based on volatility and reducing risk.

How does it fit into a portfolio?

Trend-following strategies are often uncorrelated to other asset classes, which provides diversification benefits to an investor’s portfolio. They have also been shown to perform best when markets are at their worst, providing what has been deemed ‘crisis alpha.’

If you look at the performance of momentum strategies from 1960-2015, for example, you can see that the annualised average return for the representative BTOP50 managed futures index is highest in the best and worst periods for the S&P Total Return Index. The same is true for bond markets and can be seen in the two charts below. What’s interesting is that it’s even better during the worst periods than it is in the best. For example, during the 2008 financial crisis, global stock markets lost 49.3% while the BTOP index made 16.5%.[i] The same was seen during the dot com bubble and the Covid-19 pandemic.[ii]

Integrating trend-following strategies into a long-only portfolio can therefore provide important tail-hedging properties. It enables investors to participate in the upside of markets with their long-only allocations (as well as their trend-allocations) and helps protect on the downside when crises hit. Holding stocks and trend gives higher risk-adjusted returns and lower drawdowns than holding stocks or other traditional assets alone because trend-following’s risk is significantly lower, whether risk is measured in terms of volatility or maximum drawdown. If you look at the Barclay BTOP50 Index (BTOP) and the MSCI World Net Total Return Index (MSCI World) between January 1987 and March 2023, you can see the BTOP50 had lower volatility (9.6% versus 14.4%) and a lower maximum drawdown (-16% versus -50%) than the MSCI World Index, while delivering an annualised return only 0.7% shy (7.0% vs 7.7%).[iii]

Perhaps the best thing about trend-following is that it doesn’t really matter what markets are doing. By taking advantage of a feature of markets that has been observed for thousands of years, they can profit when things are going up - or down - and provide investors with strong returns, diversification, and tail hedging all in one neat package. What’s not to like about that?

 

Kit Cherry is a Director, Sales Strategy at Man Group, a specialist investment manager partner of GSFM. GSFM Funds Management is a sponsor of Firstlinks. GSFM represents Man AHL and Man GLG in Australia. The information included in this article is provided for informational purposes only. Man Group do not represent that this information is accurate and complete, and it should not be relied upon as such. Any opinions expressed in this material reflect our judgment at this date, are subject to change and should not be relied upon as the basis of your investment decisions.

For more articles and papers from GSFM and partners, click here.

 

[i] 2008 financial crisis performance period - 1 July 2007 to 28 Feb 2009
[ii] Dot com bubble performance period – 1 Apr 2000 to 31 Mar 2003; Covid-19 performance period – 1 Feb 2020 to 31 Mar 2020
[iii] Source: Man Group, BarclayHedge, Bloomberg; between 1 January 1987 to 31 March 2023.

 

RELATED ARTICLES

Howard Marks on the best opportunities in 2024

banner

Most viewed in recent weeks

Pros and cons of Labor's home batteries scheme

Labor has announced a $2.3 billion Cheaper Home Batteries Program, aimed at slashing the cost of home batteries. The goal is to turbocharge battery uptake, though practical difficulties may prevent that happening.

Howard Marks: the investing game has changed

The famed investor says the rapid switch from globalisation to trade wars is the biggest upheaval in the investing environment since World War Two. And a new world requires a different investment approach.

Welcome to Firstlinks Edition 606 with weekend update

The boss of Australia’s fourth largest super fund by assets, UniSuper’s John Pearce, says Trump has declared an economic war and he’ll be reducing his US stock exposure over time. Should you follow suit?

  • 10 April 2025

4 ways to take advantage of the market turmoil

Every crisis throws up opportunities. Here are ideas to capitalise on this one, including ‘overbalancing’ your portfolio in stocks, buying heavily discounted LICs, and cherry picking bombed out sectors like oil and gas.

An enlightened dividend path

While many chase high yields, true investment power lies in companies that steadily grow dividends. This strategy, rooted in patience and discipline, quietly compounds wealth and anchors investors through market turbulence.

Tariffs are a smokescreen to Trump's real endgame

Behind market volatility and tariff threats lies a deeper strategy. Trump’s real goal isn’t trade reform but managing America's massive debts, preserving bond market confidence, and preparing for potential QE.

Latest Updates

Investment strategies

Getting rich vs staying rich

Strategies to get rich versus stay rich are markedly different. Here is a look at the five main ways to get rich, including through work, business, investing and luck, as well as those that preserve wealth.

Investment strategies

Does dividend investing make sense?

Dividend investing offers steady income and behavioral benefits, but its effectiveness depends on goals, market conditions, and fundamentals - especially in retirement, where it may limit full use of savings.

Economics

Tariffs are a smokescreen to Trump's real endgame

Behind market volatility and tariff threats lies a deeper strategy. Trump’s real goal isn’t trade reform but managing America's massive debts, preserving bond market confidence, and preparing for potential QE.

Strategy

Ageing in spurts

Fascinating initial studies suggest that while we age continuously in years, our bodies age, not at a uniform rate, but in spurts at around ages 44 and 60.

Interviews

Platinum's new international funds boss shifts gears

Portfolio Manager Ted Alexander outlines the changes that he's made to Platinum's International Fund portfolio since taking charge in March, while staying true to its contrarian, value-focused roots.

Investment strategies

Four ways to capitalise on a forgotten investing megatrend

The Trump administration has not killed the multi-decade investment opportunity in decarbonisation. These four industries in particular face a step-change in demand and could reward long-term investors.

Strategy

How the election polls got it so wrong

The recent federal election outcome has puzzled many, with Labor's significant win despite a modest primary vote share. Preference flows played a crucial role, highlighting the complexity of forecasting electoral results.

Sponsors

Alliances

© 2025 Morningstar, Inc. All rights reserved.

Disclaimer
The data, research and opinions provided here are for information purposes; are not an offer to buy or sell a security; and are not warranted to be correct, complete or accurate. Morningstar, its affiliates, and third-party content providers are not responsible for any investment decisions, damages or losses resulting from, or related to, the data and analyses or their use. To the extent any content is general advice, it has been prepared for clients of Morningstar Australasia Pty Ltd (ABN: 95 090 665 544, AFSL: 240892), without reference to your financial objectives, situation or needs. For more information refer to our Financial Services Guide. You should consider the advice in light of these matters and if applicable, the relevant Product Disclosure Statement before making any decision to invest. Past performance does not necessarily indicate a financial product’s future performance. To obtain advice tailored to your situation, contact a professional financial adviser. Articles are current as at date of publication.
This website contains information and opinions provided by third parties. Inclusion of this information does not necessarily represent Morningstar’s positions, strategies or opinions and should not be considered an endorsement by Morningstar.