Does trend following work on stocks? Part II
Trend following involves selling or avoiding assets that are declining in value, buying or holding assets that are rising in value, and
actively managing the amount of risk taken. It is commonly associated with the managed futures industry and is the core strategy of
many commodity trading advisors. However, it is rarely considered as an approach to stock market investing. Does this mean trend
following doesn’t work on stocks? We attempt to answer this question by applying several basic trend following systems to a broad
universe of U.S. stocks using 20 years of historical data (1989 – 2008).
By our definition, a complete trend following system is a rules-based process that determines what to buy and when to buy, what to
sell and when to sell, as well as how much to buy or sell. The process must be clear, executable, and repeatable.
What to buy/sell
Our trend following systems will consider approximately the 3,000 most liquid stocks during each year of the simulation period. This
universe of stocks is estimated to represent 95% to 98% of the investable U.S. equity market in any given year.
When to buy/sell
A simple channel breakout entry/exit method is perhaps the easiest trend following approach to understand. For example, using an
18 month breakout setting, a stock is purchased after it appreciates to an 18 month high (channel top). Likewise, a stock is sold after
falling below an 18 month low (channel bottom).
$100
Trend follwing isn't just
concerned with up-trends.
Avoiding down-trends is
just as important.
$10
Ambac Financial
18 month low
18 month high
$1
1995
1996
1997
1998
1999
2000
2001
2002
2003
2004
2005
2006
2007
2008
How much to buy/sell
For this project we use a simplified version of the same money management framework used to manage our clients’ assets. Starting
1
with a portfolio risk target of 25% we attempt to spread no more than this amount of risk across all portfolio holdings on an “equal
risk” basis. An individual position’s actual risk is estimated to be the (current stock price) minus the (channel bottom price),
multiplied by the (number of shares owned). If any position’s actual risk exceeds “equal risk” by a factor of two, the position is
rebalanced the following day. This process works to keep portfolio risk under control and individual stocks approximately “equal
risk” weighted. During periods of high volatility, restricting portfolio risk to approximately 25% will often force the portfolio to hold
a cash balance. Likewise, during periods of low volatility the portfolio will often use a variable amount of leverage (appendix B).
Unlike most traditional investments the goal here is to take a prudent amount of risk rather than to stay 100% invested at all times.
Results are also shown without this money management framework. In this scenario no attempt is made to limit future “worst case”
portfolio declines. In other words, the portfolio is forced to remain 100% invested at all times, like a typical index or mutual fund.
1. Portfolio risk target – represents the desired limit with respect to the future worst-case decline in portfolio value
HYPOTHETICAL PERFORMANCE DISCLAIMER:
HYPOTHETICAL PERFORMANCE RESULTS HAVE MANY INHERENT LIMITATIONS, SOME OF WHICH ARE DESCRIBED BELOW. NO REPRESENTATION
IS BEING MADE THAT ANY ACCOUNT WILL OR IS LIKELY TO ACHIEVE PROFITS OR LOSSES SIMILAR TO THOSE SHOWN. IN FACT, THERE ARE
FREQUENTLY SHARP DIFFERENCES BETWEEN HYPOTHETICAL PERFORMANCE RESULTS AND THE ACTUAL RESULTS SUBSEQUENTLY ACHIEVED BY
ANY PARTICULAR TRADING PROGRAM. ONE OF THE LIMITATIONS OF HYPOTHETICAL PERFORMANCE RESULTS IS THAT THEY ARE GENERALLY
PREPARED WITH THE BENEFIT OF HINDSIGHT. IN ADDITION, HYPOTHETICAL TRADING DOES NOT INVOLVE FINANCIAL RISK, AND NO
HYPOTHETICAL TRADING RECORD CAN COMPLETELY ACCOUNT FOR THE IMPACT OF FINANCIAL RISK IN ACTUAL TRADING. FOR EXAMPLE, THE
ABILITY TO WITHSTAND LOSSES OR TO ADHERE TO A PARTICULAR TRADING PROGRAM IN SPITE OF TRADING LOSSES ARE MATERIAL POINTS
WHICH CAN ALSO ADVERSELY AFFECT ACTUAL TRADING RESULTS. THERE ARE NUMEROUS OTHER FACTORS RELATED TO THE MARKETS IN
GENERAL OR TO THE IMPLEMENTATION OF ANY SPECIFIC TRADING PROGRAM WHICH CANNOT BE FULLY ACCOUNTED FOR IN THE
PREPARATION OF HYPOTHETICAL PERFORMANCE RESULTS AND ALL OF WHICH CAN ADVERSELY AFFECT ACTUAL TRADING RESULTS.
Please see appendix A of this document for disclosure of assumptions used in calculating hypothetical performance. These include
transaction costs (slippage and commissions), delisted stocks, corporate actions (mergers, spin-offs, distributions, dividends, etc.),
liquidity filters, and interest rates applied to cash and/or margin balances. Portfolio results were generated using The Power System
Tester from RDB Computing, Inc. www.PowerST.com
Simulated performance with money management
18 month
breakout
12 month
breakout
9 month
breakout
6 month
breakout
3 month
breakout
2 month
breakout
1 month
breakout
S&P 500
total return
index
Russell 2000
total return
index
1989
1990
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
2003
2004
2005
2006
2007
2008
28.4%
-8.3%
39.1%
13.5%
17.0%
-1.9%
36.9%
21.3%
28.3%
2.0%
17.9%
7.9%
4.2%
-5.2%
36.7%
17.5%
8.7%
19.8%
6.4%
-26.5%
31.9%
-6.1%
33.4%
12.7%
17.2%
-2.2%
33.1%
20.0%
25.8%
3.1%
15.8%
9.4%
5.3%
-5.4%
34.3%
16.0%
9.5%
18.8%
6.5%
-25.0%
31.9%
-5.8%
30.9%
12.7%
15.3%
-2.4%
30.6%
19.1%
25.0%
3.8%
14.3%
9.6%
4.1%
-7.9%
35.2%
16.2%
9.0%
18.0%
6.3%
-26.4%
30.8%
-7.6%
30.4%
12.2%
13.9%
-3.9%
28.9%
17.9%
23.5%
5.5%
14.1%
10.7%
2.2%
-8.8%
35.1%
17.5%
7.6%
17.8%
6.5%
-24.1%
28.6%
-3.1%
29.9%
13.1%
12.2%
-3.1%
27.5%
16.2%
20.1%
2.6%
14.7%
9.1%
0.2%
-8.5%
29.7%
15.3%
6.3%
17.0%
3.4%
-20.6%
27.8%
-2.0%
26.9%
11.6%
12.0%
-3.4%
26.3%
15.9%
20.4%
1.7%
13.7%
9.5%
-1.2%
-10.7%
28.7%
12.8%
5.6%
15.9%
0.6%
-16.3%
24.0%
-4.0%
24.7%
7.9%
12.2%
-5.5%
25.8%
14.1%
20.0%
-1.0%
13.8%
9.5%
0.3%
-11.7%
28.1%
13.1%
3.0%
13.4%
-2.1%
-20.4%
32.0%
-3.4%
31.0%
7.6%
10.2%
1.2%
38.0%
23.1%
33.7%
28.7%
21.1%
-9.1%
-12.0%
-22.3%
28.7%
10.8%
4.8%
15.7%
5.5%
-37.2%
16.3%
-19.5%
46.0%
18.4%
18.9%
-1.8%
28.5%
16.5%
22.4%
-2.5%
21.3%
-3.0%
2.5%
-20.5%
47.3%
18.3%
4.6%
18.4%
-1.6%
-33.8%
Annualized Return
11.9%
12.4%
0.62
0.69
-30.8%
853%
11.6%
11.1%
0.65
0.62
-28.7%
803%
10.9%
10.8%
0.60
0.59
-29.5%
690%
10.5%
10.6%
0.57
0.57
-27.7%
634%
9.7%
9.7%
0.54
0.53
-24.5%
537%
9.0%
9.5%
0.49
0.51
-22.4%
465%
7.5%
10.0%
0.32
0.55
-27.9%
321%
8.4%
14.4%
0.32
1.00
-44.9%
405%
7.9%
18.6%
0.26
0.99
-43.0%
354%
Annualized Volatility
Sharpe Ratio (rf=4.6%)
Beta (S&P 500)
Maximum Drawdown
Total Return
Please see appendix B for leverage/cash balances resulting from money management.
Simulated performance without money management
18 month
breakout
12 month
breakout
9 month
breakout
6 month
breakout
3 month
breakout
2 month
breakout
1 month
breakout
S&P 500
total return
index
Russell 2000
total return
index
1989
1990
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
2003
2004
2005
2006
2007
2008
29.1%
-7.5%
38.6%
15.2%
18.4%
-1.9%
38.1%
23.7%
32.0%
3.0%
26.8%
6.9%
5.4%
-6.2%
44.0%
21.8%
10.4%
21.2%
6.4%
-43.3%
28.7%
-7.3%
37.2%
15.4%
19.7%
-2.9%
35.8%
24.4%
31.6%
1.7%
25.6%
10.5%
7.5%
-7.6%
45.0%
21.4%
11.4%
21.1%
6.7%
-41.9%
29.3%
-7.8%
37.4%
15.2%
18.4%
-3.4%
34.5%
24.4%
31.6%
0.8%
25.6%
11.4%
6.0%
-13.0%
46.5%
21.5%
11.0%
20.9%
7.0%
-42.5%
29.5%
-9.3%
40.3%
13.2%
17.8%
-5.8%
34.2%
22.6%
29.3%
-0.1%
26.7%
12.9%
3.4%
-16.5%
45.6%
20.4%
10.1%
19.4%
7.6%
-39.7%
29.4%
-9.6%
44.5%
15.1%
16.8%
-6.5%
35.2%
20.1%
28.5%
-2.0%
25.1%
12.1%
-3.2%
-18.7%
43.3%
17.7%
7.3%
18.6%
3.7%
-42.8%
29.0%
-9.9%
43.2%
13.9%
16.7%
-7.0%
34.4%
19.9%
27.3%
-2.2%
24.6%
14.3%
-7.2%
-21.6%
41.3%
16.1%
6.5%
17.5%
-0.8%
-40.8%
24.1%
-13.6%
35.4%
10.9%
15.3%
-9.7%
33.0%
17.4%
21.7%
-4.4%
22.5%
17.1%
-1.9%
-20.0%
37.9%
14.4%
3.2%
15.5%
-4.8%
-46.1%
32.0%
-3.4%
31.0%
7.6%
10.2%
1.2%
38.0%
23.1%
33.7%
28.7%
21.1%
-9.1%
-12.0%
-22.3%
28.7%
10.8%
4.8%
15.7%
5.5%
-37.2%
16.3%
-19.5%
46.0%
18.4%
18.9%
-1.8%
28.5%
16.5%
22.4%
-2.5%
21.3%
-3.0%
2.5%
-20.5%
47.3%
18.3%
4.6%
18.4%
-1.6%
-33.8%
Annualized Return
12.1%
15.9%
0.52
0.90
-47.0%
876%
12.2%
15.7%
0.53
0.87
-45.6%
907%
11.7%
15.9%
0.50
0.86
-45.9%
808%
11.0%
15.7%
0.46
0.84
-43.6%
712%
9.5%
15.8%
0.36
0.86
-47.3%
510%
8.5%
15.6%
0.32
0.86
-47.5%
416%
6.2%
15.8%
0.18
0.90
-53.3%
231%
8.4%
14.4%
0.32
1.00
-44.9%
405%
7.9%
18.6%
0.26
0.99
-43.0%
354%
Annualized Volatility
Sharpe Ratio (rf=4.6%)
Beta (S&P 500)
Maximum Drawdown
Total Return
Money management versus 100% invested at all times
Entry/Exit
Annualized
Return
money
mgmt
100%
invested
Annualized
Volatility
money
mgmt
Sharpe Ratio
(rf=4.6%)
100%
invested
money
mgmt
100%
invested
Beta
(S&P 500)
money
mgmt
Maximum
Drawdown
100%
invested
money
mgmt
100%
invested
Total
Return
money
mgmt
100%
invested
1 month
11.9%
11.6%
10.9%
10.5%
9.7%
9.0%
7.5%
12.1%
12.2%
11.7%
11.0%
9.5%
8.5%
6.2%
12.4%
11.1%
10.8%
10.6%
9.7%
9.5%
10.0%
15.9%
15.7%
15.9%
15.7%
15.8%
15.6%
15.8%
0.62
0.65
0.60
0.57
0.54
0.49
0.32
0.52
0.53
0.50
0.46
0.36
0.32
0.18
0.69
0.62
0.59
0.57
0.53
0.51
0.55
0.90
0.87
0.86
0.84
0.86
0.86
0.90
-30.8%
-28.7%
-29.5%
-27.7%
-24.5%
-22.4%
-27.9%
-47.0%
-45.6%
-45.9%
-43.6%
-47.3%
-47.5%
-53.3%
853%
803%
690%
634%
537%
465%
321%
876%
907%
808%
712%
510%
416%
231%
Average
10.2%
10.2%
10.6%
15.8%
0.54
0.41
0.58
0.87
-27.4%
-47.2%
615%
637%
18 months
12 months
9 months
6 months
3 months
2 months
Summary
Our goal was to illustrate the potential of trend following as a general approach to stock market investing. A simple trend following
system with very few moving parts was purposely chosen, to avoid curve-fitting. This system was applied to all reasonably liquid
U.S. stocks that traded from 1989 to 2008, including delisted stocks. Results are shown for a broad spectrum of practical time
frames, from 1 month breakouts to 18 month breakouts.
Simulated performance results with money management suggest that even a very simple approach to trend following over the last
20 years would have yielded substantially higher Sharpe ratios than traditional stock market indices. Trend following would have
enjoyed higher annual returns, lower volatility, and modest beta relative to the general stock market. Simulated performance
results without money management are less impressive, as expected. However, annual returns and Sharpe ratios are still
significantly higher to those of traditional stock market indices, while drawdowns and annual volatilities are approximately the same.
Eric Crittenden
Research Director
eric@blackstarfunds.com
602.910.6957
Cole Wilcox
Managing Director
cole@blackstarfunds.com
602.910.6959
Blackstar Funds, LLC
1850 North Central Ave. Ste 630
Phoenix, AZ 85004
USA
Appendix A
Annualized performance data
Monthly data points were used for annualized volatility, beta, and maximum drawdown calculations. Sharpe ratio calculations used
the time-period relevant monthly Federal Funds rate to calculate excess return.
Transaction costs & trade executions
Combined slippage and commissions were estimated to be 0.5% per trade, half of which was applied on the day of entry and half on
the day of exit. Executions were assumed at the market open on the day following the entry or exit signal.
Delisted stocks
The scope of this project included over 30,000 individual securities that traded on U.S. exchanges (AMEX, NYSE & NASDAQ),
including 16,218 delisted securities.
Corporate actions
Cash dividends were assumed reinvested on the relevant ex-dividend date. Price data was proportionately back-adjusted for cash
dividends to yield “total return” format. Stock splits, stock dividends, reverse splits, mergers, divestitures, etc. were also
proportionately back adjusted for. Buy and sell signals, as well as profits and losses, were calculated from “total return” data.
Liquidity filters
Simulated trading was limited to stocks above $5 (actual price, not split-adjusted) and among the approximately 3,000 most liquid
U.S. stocks (at the time of the trade). Liquidity estimates used only price and volume data that was available prior to trade signal (to
avoid postdictive error).
Interest rates
Cash balances were assumed to collect (annualized Federal Funds rate at the time, less 0.25%) expressed in daily terms. Margin
balances were assumed to pay (annualized Federal Funds rate at the time, plus 0.25%) expressed in daily terms.
Appendix B
Average exposure for all systems was less than 100%, indicating cash balances. Maximum exposures rarely exceeded 120%,
indicating very modest use of leverage.
Exposure by system
140%
120%
Net Exposure
100%
80%
Average
Maximum
60%
Minimum
40%
20%
0%
18 months
Average
Maximum
Minimum
18 months
83%
126%
26%
12 months
12 months
76%
126%
25%
9 months
6 months
9 months
73%
120%
23%
3 months
6 months
72%
120%
21%
2 months
3 months
67%
110%
15%
1 month
2 months
66%
108%
12%
1 month
69%
112%
15%
All
72%
117%
20%