Back to Basics for Trend-Following – It is All About What It Does to the Portfolio

It does matter what an investment strategy will do on a stand-alone basis; however, it really matters what an investment will do when added to an already diversified portfolio. For any strategy allocation decision, it is all about the marginal contribution to portfolio return and risk. Most investors know this intuitively, but they often do not focus on the marginal portfolio contribution in practice.

The charts below are from Credit Suisse Asset Management (CSAM) who has developed the CS liquid beta managed futures trend-following index which offers a low cost trend-following program alternative. It is a close proxy for a pure trend-following beta program.

A simple way to measure the marginal contribution is to add trend-following to a 60/40 stock/bond portfolio while preserving the original proportions of the mix. This would lead to a 54/36/10 allocation if 10% is given to the trend-following program or a 48/32/20 allocation if 20% was given to the trend-following program.

Whether returns are higher or lower will be situational based on relative equity and bond performance versus the trend-following program. In the last year, the allocation away from equities would have been a drag on performance, but depending on the program chosen, the fixed income reallocation would have generated about the same or better return.

The real gain from adding trend-following comes from the diversification benefit which would have pushed the efficient frontier outward to increase the number of risk and return combinations.

Performance would still maintain the same pattern when trend-following is added to the portfolio, but the return lows would be smoothed-out and not as deep. The gains from reducing drawdowns will last for a very long time. Not losing money is still one of the best ways to ensure future success. Trend-following that will allocate away from losing positions is still the easiest active strategy for cutting drawdowns.

While trend-following may not have generated superior performance this year to a buy and hold portfolio of equities, we are starting the new year in less than two weeks and it requires asking a simple question. Would you prefer holding your existing stock/bond mix or would you like to gain some active exposure through trend-following. The trend-following programs will give your portfolio asset allocation tilts during times of uncertainty.