ILIM Spotlight Trend Following

Trend following (aka Managed Futures or CTA) is a strategy ILIM deploys as a core part of our alternatives portfolios. It’s one of the oldest alternative investment strategies around and has a track record of delivering valuable, highly diversifying returns. But what is it, how does it work, what can go wrong and why is it so useful in a multi-asset portfolio?

What is it?

Trend following is an investment strategy that aims to identify price trends and buy/sell into that trend once it is deemed strong enough. Once the manager identifies that the trend has ceased, they will look to exit the position. It can be referred to as trend following, CTAs or managed futures, but it all amounts to the same thing. Managers employing this strategy are typically looking to exploit price trends when they emerge.

These strategies usually share some characteristics like:

• Quantitative or rules based: They will have algorithms that identify when a trend has begun or ended and do not take any discretionary positions.
• Highly diversified: Trend followers will look to spread their exposures across as many liquid markets as possible and will typically cover numerous regional equity indices, fixed income, commodities and FX.
• Trade futures or derivatives: They typically trade indices rather than individual stocks and will usually have all their investments in futures, which are very liquid contracts that allow them to get exposure without tying up their cash, so they will have most of their cash on deposit or in US Treasury bills.

Strategy example

Cocoa is a commodity which has experienced the various phases associated with trend following in 2024. In the chart below, we can see how the trend forms and then it experiences a sharp elbow upwards: a classic trend breakout and exactly the sort of event trend followers are looking for. But the trend looks like it gets over-bought and experiences a sharp reversal. That is followed up with several false starts where momentum looks to be building only to reverse course.

Why do we use it?

Trend following is a great source of uncorrelated returns, so it’s a useful diversifier for multi-asset portfolios with equity and bond allocations. That’s why it’s a core allocation within our alternatives portfolio.

Trend followers are entirely agnostic as to the direction of the trend; they are only interested in the strength of the trend. So, while there will be times when they are positively exposed to equities and bonds, there will also be times when they are negatively exposed. On top of this, they will have exposures to commodities and FX according to how they are trending. When you bundle all of that together you get a strategy which on average has no correlation with equities or bonds. And because it relies on algorithms and not star traders, it’s relatively cost efficient too.

If we think about the best ways to diversify equity risk in a portfolio, the main asset types that spring to mind are bonds and commodities, but trend following is arguably as effective as bonds and has historically done a better job than commodities.

As we can see from the table below, since 1999, the Soc Gen Trend Following index has delivered similar returns to bonds, albeit with higher volatility, and with slightly lower equity beta. Meanwhile, commodities have struggled on every metric, with low returns, high volatility and have fallen with equities in several drawdown events.

What are the risks?

Trend following is a strategy which experiences lots of periods where performance is flat or down modestly, with shorter bursts where they earn high returns. We call this a ‘lumpy return profile’, where the money is made in big lumps, surrounded by longer fallow periods including periods of over five years where the strategy is flat or down. This means that the asset allocator who invests in trend has to have patience, and ensure stakeholders understand what they are in for.

How do we allocate to it?

A lot of trend followers’ returns look quite similar to each other. A trend is a trend, and if one manager is able to capture it, others probably will too. The differences tend to be around the fringes.

We partner with trend managers who have the strategy embedded in their DNA and for whom it is a core strategy rather than a side hustle, who are committed to ongoing research and reducing costs associated with trading.

Summary

At ILIM, we are believers in deep diversification. Bonds are the most established diversifier for equity risk and with good reason: they pay a coupon and act as a safe port in a storm. But no portfolio can ever have too much diversification.

There are environments, like in 2022, when equities and bonds fall together. Our trend following strategy gained over 26% in 2022, delivering valuable returns to defend capital in a year when equities and bonds both fell by double digits. That’s the principle of deep diversification in action and a concrete example of how non-traditional alternative allocations such as trend following are worth having in a multi-asset portfolio.