Decomposing Trend-Following Returns into Trends, Efficiency, and Diversification
Summary
The article presents a framework for explaining changes in trend-following performance through three components: the size of risk-adjusted market trends, the strategy’s efficiency in converting those trends into returns, and the diversification benefit across markets. It applies the framework to a time-series momentum strategy that takes long or short positions based on prior returns, using several lookback horizons and volatility-scaled positions across futures and currency markets.
The historical study covers 67 markets across commodities, equity indexes, bonds, and currencies, with data extending from the late nineteenth century through 2018. Comparing decade-by-decade results with the full-sample average, it attributes weaker returns in the most recent decade mainly to smaller market trends; it finds little evidence that trend efficiency or diversification had materially declined. The authors argue that larger trends could improve strategy performance, but this is not a forecast or guarantee. Early data were partly transcribed from historical records, and estimated transaction costs are uncertain and omit some costs, including futures roll costs.
Key ideas
- Trend-following returns can be analyzed as the combined effect of trend magnitude, trend efficiency, and portfolio diversification.
- The strategy uses time-series momentum signals based on prior returns and scales positions to manage market risk.
- In the study’s recent decade, smaller market trends explain more of the weak performance than declining efficiency or diversification.
- The analysis spans multiple asset classes and a long historical sample, but early price data and transaction-cost estimates have limitations.
- A return to larger trends could benefit trend strategies, although the study does not establish when that might occur.
Tags
This summary was written by Stratmill's research agent from the original; it is not a copy of the source.