An Unconventional Risk-Management Tool

by: Morningstar

By Alex Bryan

Fear and greed make most investors awful market-timers. It's easy to get excited about an investment after a period of good performance when valuations become stretched, only to turn around and dump it after the pain of a market downturn becomes too much to bear. This behavior is not entirely irrational. Large drawdowns at inopportune times can create a serious threat to investors' goals. It's sad to recall stories of investors who had to liquidate a significant portion of their investments in 2008 and 2009 to finance a large purchase or living expenses in retirement. The right time to plan for market downturns is before they happen. Trend-following may be an effective strategy to reduce the risk of large losses and volatility in a tax-sheltered account.

Trend-following is a rules-based market-timing strategy that attempts to take advantage of momentum in asset prices. Where traditional momentum strategies target assets that have recently outperformed their peers, trend-following is based on time series momentum. For instance, this strategy might buy assets that have exceeded their moving averages and sell those that have dropped below. It could work if investors under-react to new information, such as improving or deteriorating fundamentals, or pile into a trade once a trend is established.

Mebane Faber, co-founder and chief investment officer at Cambria Investment Management, investigated a simple trend-following strategy in a study updated last year (1). At the end of each month, he compared the price of the S&P 500 Index with its 10-month simple moving average. The strategy bought the S&P 500 when the index's value exceeded its moving average and moved into 90-day T-bills when its value fell below the moving average. In order to avoid excessive trading, the strategy ignored all price movements during the month.

Using data from 1901 through 2012, he found that this strategy offered a slightly higher return than the S&P 500 Index, with lower volatility and significantly better returns during market downturns. This is because the market's worst periods tend to persist for many months. The trend-following strategy often kicked investors out of the market before things got really bad. However, it also underperformed during strong bull markets. This strategy appeared to work across several different asset classes and with moving average signals ranging from three to 12 months. Faber argued that the success of this strategy was due to its lower volatility, which reduces drag on returns.

As a check, I tested the 10-month moving-average strategy using the total-return versions of the S&P 500 and the MSCI EAFE Index (which represents developed-markets stocks) from January 1970 through July 2014. However, I substituted the 30-day T-bill for the 90-day. I ran the same strategy with the Barclays U.S. Aggregate Bond and MSCI Emerging Markets Indexes using data starting in December 1975 and 1987, respectively. Consistent with Faber's findings, all four trend-following strategies I constructed exhibited less volatility and lower maximum drawdowns--the largest peak to trough loss--than their corresponding indexes. This reduction in volatility was significant because the market tends to be more volatile when it is below its moving average. These hypothetical trend-following strategies moved to T-bills during those periods. However, each strategy was invested in its respective index most of the time because the market has tended to appreciate over time.

The S&P 500 strategy generated a comparable return to the index, while the MSCI EAFE and Emerging Market strategies both outperformed by about 0.8% annualized. However, these single-point estimates mask variation in their relative performance. The chart below illustrates the returns of each trend-following strategy against its index. When a line is upward sloping, the strategy is outperforming, when it is downward sloping, it is underperforming. As the chart shows, the equity strategies tended to fare well during bear markets, particularly after the dot-com bubble burst and during the global financial crisis. The emerging-markets trend-following strategy also did well during the 1997-98 currency crisis. It moved to T-bills at the end of August 1997 and stayed there until the end of March 1999. As a result, it avoided the worst of the crisis.

Sources: Morningstar Direct and analyst calculations.

While the equity strategies tended to fare well during market downturns, they had trouble keeping up during some of the bull markets. As late as 2007, the S&P trend-following strategy would have underperformed the index itself since its inception. In other words, these strategies do not represent a free lunch. Rather, they may serve as useful risk-management tools.

The bond trend-following strategy did little to improve performance. This may be because U.S. investment-grade bonds have benefited from a secular decline in interest rates over the past 30 years and have exhibited very low volatility. However, trend-following may be more appealing for riskier asset classes. While it may not be significant, it is interesting to note that the more volatile the underlying index was, the more the trend-following strategy improved risk-adjusted returns, as measured by the Sharpe ratio.

Practical Considerations
As a practical matter, trend-following is most suitable for tax-sheltered accounts. Although trend-following usually requires few trades, and most of its realized gains tend to be long term, these strategies' turnover is routinely more than 100%. In a taxable account, that means virtually all gains would be taxed each year, which can create a significant drag on performance relative to a buy-and-hold approach. That said, the strategy is very manageable in a retirement account, where protecting against large drawdowns could make a big difference, especially for investors approaching retirement.

Investors can implement a trend-following strategy with virtually any fund. Schwab U.S. Aggregate Bond ETF (NYSEARCA:SCHZ) (0.06% expense ratio), Vanguard S&P 500 ETF (NYSEARCA:VOO) (0.05%), iShares MSCI EAFE (NYSEARCA:EFA) (0.34%), and iShares MSCI Emerging Markets (NYSEARCA:EEM) (0.67%) offer exposure to the indexes mentioned in this article. iShares Core MSCI EAFE (NYSEARCA:IEFA) (0.14%) and iShares Core MSCI Emerging Markets (NYSEARCA:IEMG) (0.18%) offer very similar exposure to EFA and EEM, respectively, at a fraction of the price.

(1) Faber, Mebane. "A Quantitative Approach to Tactical Asset Allocation." The Journal of Wealth Management, Spring 2007 (February 2013 Update):

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