- Speaker #0
Hello, welcome back to Papers with Backdesk podcast. Today we dive into another algo trading research paper.
- Speaker #1
Oh, this is going to be fun.
- Speaker #0
Yeah, it is. This one's a cool one. I like this one. We're looking at what's called asset class trend following.
- Speaker #1
Okay.
- Speaker #0
And, you know, I think you'll probably recognize some of the concepts here. The idea is to exploit momentum by timing entries into different asset classes. Ah,
- Speaker #1
makes sense.
- Speaker #0
Kind of like, you know, riding a wave when it's going up. Yeah. Jumping off before it crashes down.
- Speaker #1
Right. So buy the dips, sell the rips, or is this the opposite?
- Speaker #0
This is the opposite. This is the opposite. And what's fascinating about this strategy, and this is something you brought up earlier, it's not new. It's got roots in academic research.
- Speaker #1
Yeah. And it's been popularized, you know, by some folks like Meb Faber.
- Speaker #0
Meb Faber, yeah.
- Speaker #1
And the paper that we're discussing today is actually an update to his original 2006 white paper.
- Speaker #0
So this isn't just some fly-by-night idea. No. This is a... It's got some staying power. It's been around for a while.
- Speaker #1
Yeah, it's been tested. It's been tried. They've been iterated on it.
- Speaker #0
Exactly. And this updated research adds even more insights, like how this strategy works and how you can tailor it to different market conditions.
- Speaker #1
Right. So let's get into it. How are they doing this trend following? What are the specifics?
- Speaker #0
All right. So let's dive into the nitty gritty. How does this asset class trend following strategy work? Well, the paper backtests this strategy. On a portfolio of five ETFs, SPY, which is for U.S. stocks, EFA for foreign stocks, BND for bonds. OK. VNQ for REITs and GSG for commodities.
- Speaker #1
So a pretty diverse mix of assets there.
- Speaker #0
Yeah, it's got a little bit of everything pretty much.
- Speaker #1
Yeah. The idea is to capture a broad range of market trends. Right. Now, the rule itself is actually really simple. Hold each ETF only when its price is above its 10-month simple moving average. I didn't know that. OK. If it dips below that average, you sell and move your money into cash.
- Speaker #0
So it sounds pretty simple, right? Yeah. So you're only in the market when the trend is up and you're sitting on the sidelines when things start to head south.
- Speaker #1
You're out of the market. Yeah.
- Speaker #0
I mean, that sounds intuitive. Like that's kind of what you would think you would want to do.
- Speaker #1
Exactly. Buy low, sell high. The issue is that people buy high and they sell low.
- Speaker #0
Well, or you buy high and then they hold all the way down and then they sell low.
- Speaker #1
And then they sell. Right.
- Speaker #0
But I mean, that sounds like a pretty intuitive way to manage risk.
- Speaker #1
Yeah, for sure.
- Speaker #0
Just getting out when things start to look bad.
- Speaker #1
Yep. Yep.
- Speaker #0
So, I mean, how did this do in the back test? Is this something that...
- Speaker #1
I think the results are really cool. Okay. So they found that this really simple strategy delivered an average annual return of 11.27%. Wow. With a maximum drawdown of just a native
- Speaker #0
9.53%. That's a pretty good combination.
- Speaker #1
Yeah. So you're potentially getting equity-like returns with... bond like volatility.
- Speaker #0
That's exactly what I was going to say. Yeah.
- Speaker #1
Which is which is great. I mean, it's, you know, especially for people that don't want to, you know, or that want a much smoother ride. Right. And they don't want to worry about those crashes. You know, those 2008, 2020 crashes.
- Speaker #0
Yeah. Because some of those are scary.
- Speaker #1
They're really scary. Yeah.
- Speaker #0
So I guess the first thing that pops in my mind is like, OK, but wouldn't sitting in cash for long periods of time drag down the returns, especially during those times when the market's going up a lot?
- Speaker #1
It's a good question.
- Speaker #0
Like the big bull markets, you're just sitting on the sidelines.
- Speaker #1
Yeah, right. You're missing out on all that goodness. Yeah. And that's something that the researchers explored. Okay. And they found that while you might miss out on some of that upside, you know, during those big explosive periods, avoiding the major downturns more than makes up for it. Okay. But in the long run.
- Speaker #0
It's all about avoiding those big losses.
- Speaker #1
It's all about maximizing gains and minimizing losses. Right. And. And the minimizing losses is kind of the key there because it's hard to come back from those big losses.
- Speaker #0
Yeah, because once you're down 50 percent, you got to go up 100 percent just to get back to even.
- Speaker #1
It's a lot harder. Yeah.
- Speaker #0
OK, so the core strategy itself sounds pretty solid.
- Speaker #1
Yeah, really simple, effective.
- Speaker #0
But they didn't just stop there. They actually dug a little deeper and tested different variations of this to see if they could tweak it, make it even better.
- Speaker #1
Yeah, they tried to break it. Yeah. see if they could add more, more return, and also figure out kind of what, you know, if there's other areas to explore. So they looked at things like adding more asset classes to the mix. Okay. Adjusting, you know, the cap management strategy and, you know, different portfolio allocations to see if how those tweaks affected the performance.
- Speaker #0
Okay, cool. So let's start with the asset classes. Did they find that adding more to the portfolio actually made it better?
- Speaker #1
Yeah, they did. So the initial test. uses just five. Right. But they expanded it to include things like emerging markets, small cap stocks, and even gold.
- Speaker #0
Oh,
- Speaker #1
okay. So they really expanded the universe.
- Speaker #0
So even more diversification, I guess.
- Speaker #1
Exactly. The idea is that the more uncorrelated assets you have in the mix, the smoother your returns should be. Right.
- Speaker #0
And that broader diversification led to an extra 1.5% in annual returns.
- Speaker #1
Okay. So that's not a negligible amount. Yeah. And I imagine that probably helped to smooth out the volatility even further.
- Speaker #0
It does. It does. Yeah. The thing is that, you know, it adds a lot of complexity. So there's a trade-off.
- Speaker #1
Right. More moving pieces.
- Speaker #0
It's more moving pieces.
- Speaker #1
Yeah. Okay. So more assets, smoother returns, but a little bit more complexity. Correct. Okay. Let's talk about the cash management piece. What'd they find there?
- Speaker #0
So, you know, remember this strategy spends. a fair amount of time out of the market.
- Speaker #1
Okay.
- Speaker #0
So how you manage that cash can have a pretty big impact.
- Speaker #1
Right, because you don't want to just let it sit there doing nothing.
- Speaker #0
Exactly. Instead of just holding treasury bills, which offer a really low return, they tested using 10-year government bonds as the cash component.
- Speaker #1
So taking on a little bit more duration risk, but potentially getting more return from that cash portion. Yeah, exactly. And over the period that they tested, so this is from 1973 to 2012, using 10-year bonds instead of T-bills boosted the portfolio's annual return by an additional 1.37%.
- Speaker #0
That's pretty good. Yeah. That's not negligible. No,
- Speaker #1
it's not.
- Speaker #0
But wait a minute. Didn't interest rates spike in the 70s and early 80s? That's a good question. Wouldn't that have been a bad time to hold longer-term bonds?
- Speaker #1
Yeah. I mean, normally you would think, you know, when interest rates are going up, long duration bonds are going to get hammered.
- Speaker #0
Yeah, that's what's a good.
- Speaker #1
But they specifically looked at this period from 73 to 81 when rates were rising. OK. And they found that even during this bond bear market, holding 10-year bonds actually outperformed holding T-goals.
- Speaker #0
So even in a rising rate environment, you're better off, or at least historically you've been better off, taking on a little bit of duration risk. Right. Rather than just sitting in T-bills.
- Speaker #1
Right. And that's a really interesting point that we'll come back to later. Yeah. So it's interesting, right? I mean, even in those rising rate environments, taking on a little bit of duration risk has paid off historically.
- Speaker #0
It's definitely counterintuitive.
- Speaker #1
It is. Of course, we can't assume that'll always be the case, but it's something to think about. Yeah.
- Speaker #0
Past performance and all that.
- Speaker #1
Exactly. But it does suggest there might be ways to boost returns without taking on too much extra risk.
- Speaker #0
Right. Right. OK, so we've got more assets and we've got a. tweaked cash management strategy. What about adjusting the actual portfolio allocation itself?
- Speaker #1
Yeah, good question. So is a simple equal weighting always the best approach? Is it? Not necessarily. The researchers tested a few different allocation strategies to try to, you know, find something that addressed different risk tolerances. Okay. So they came up with a conservative version, a moderate version, and an aggressive version.
- Speaker #0
All right. I like where this is going. Let's break those down. Starting with the conservative approach, what does that look like?
- Speaker #1
Sure. So the conservative allocation increases the bond portion of the portfolio to 40 percent. OK. Compared to 20 percent in the moderate version. Right. And it also uses, like we just discussed, it uses the 10-year U.S. government bonds as the cash component.
- Speaker #0
Right. So you're basically tilting the portfolio towards something that's going to be a little more stable.
- Speaker #1
Exactly. Lower volatility and potentially lower returns. But yeah, more stability.
- Speaker #0
Makes sense for someone who's. you know, a little more risk averse. Right. What about the moderate version? What does that look like?
- Speaker #1
The moderate version is kind of the one we've been talking about so far. Okay. Five asset classes, equal weighting, and the 10 month moving average rule. It's like the baseline strategy. Right,
- Speaker #0
right, right. Okay. That's our starting point. Yeah. Now bring on the aggressive version. How do we crank up the heat on this strategy?
- Speaker #1
Okay. So the aggressive allocation, they actually take a more dynamic approach.
- Speaker #0
Oh, okay.
- Speaker #1
Instead of simply holding all 13 asset classes, it uses a momentum. ranking system to select the top performers.
- Speaker #0
So it's like a momentum strategy on top of a trend following strategy.
- Speaker #1
Exactly. So it looks at like the average of the 1, 3, 6, and 12 month returns to identify the six assets with the strongest momentum.
- Speaker #0
So you're always holding like the cream of the crop.
- Speaker #1
Yeah. The assets with the hottest recent performance. Interesting. And of course, each asset still needs to be above its 10 month moving average.
- Speaker #0
Right. Got to be following the trend.
- Speaker #1
To be included. If it falls below, that portion of the portfolio is moved to cash.
- Speaker #0
Makes sense. Okay. Yeah. And did they just stop at six assets or did they try anything even more concentrated?
- Speaker #1
Well, they actually tested a version where they only held the top three assets. Wow.
- Speaker #0
Okay. So really concentrating the bets there.
- Speaker #1
Yeah. And, you know, to really push the envelope, they even looked at adding leverage to the portfolio.
- Speaker #0
Oh,
- Speaker #1
wow. So basically borrowing money. To invest.
- Speaker #0
To amplify those returns.
- Speaker #1
To amplify the returns. Exactly.
- Speaker #0
Okay. So this is definitely not for your grandma's retirement account.
- Speaker #1
This is-Not for the faint of heart. But for investors who have a higher risk appetite and a longer time horizon, leverage can potentially supercharge returns.
- Speaker #0
It can, yeah, but it can also supercharge losses.
- Speaker #1
Absolutely.
- Speaker #0
So, you know, it's a double-edged sword.
- Speaker #1
Yeah, you got to be careful. It's a tool that needs to be used with Ausha, for sure.
- Speaker #0
For sure. Okay, so we've got a whole spectrum of options here. Conservative, moderate, aggressive, even the option to add leverage.
- Speaker #1
Lots of choices.
- Speaker #0
It's pretty cool how flexible this strategy is.
- Speaker #1
It is. You can tailor it to your needs and your comfort level. But before we get ahead of ourselves, I think it's really important to understand that. what's driving the success of the strategy in the first place. OK. And it all comes down to something called volatility clustering.
- Speaker #0
Volatility clustering. This is what we were talking about earlier. Yeah,
- Speaker #1
you got it.
- Speaker #0
And it seems like that's the secret sauce that makes this whole thing tick. So can you explain what that is exactly?
- Speaker #1
Sure. So essentially, it means that market volatility doesn't happen in a nice, steady, predictable way. It tends to come in bunches. You know, you'll have periods of relative calm. Right. Followed by bursts of intense volatility. And often that volatility happens when the market is heading south.
- Speaker #0
That makes sense. This strategy is basically designed to avoid those volatile drops,
- Speaker #1
right? Exactly. It gets you out of the market when the risk is highest.
- Speaker #0
Okay. So you're not just avoiding volatility altogether, you're avoiding it when it matters the most.
- Speaker #1
Exactly. And then you're getting back in when things start to calm down.
- Speaker #0
And the returns are potentially better.
- Speaker #1
Right.
- Speaker #0
Okay. So how does this strategy actually identify those periods when volatility is picking up and it's time to get out?
- Speaker #1
Well, it all comes down to the 10-month moving average rule. Right. If an asset's price is above its 10-month moving average, it's considered to be in an uptrend. Okay. And it's worth holding. If it drops below, that's a signal that the trend might be reversing, and it's time to step aside.
- Speaker #0
So basically, that moving average is like a filter to help separate the signal from the noise.
- Speaker #1
You got it. And by following that rule systematically, you're essentially letting the market tell you what to do.
- Speaker #0
You're not trying to predict the future. Nope. You're not trying to, you know, time the market perfectly.
- Speaker #1
You're just reacting to what the market is telling you.
- Speaker #0
You're reacting to what it's doing.
- Speaker #1
That's the beauty of it. And that's why the strategy can be so effective. It takes the emotion out of investing and helps you stay disciplined even when things are getting crazy.
- Speaker #0
Yeah, because it's hard to be disciplined, especially when the market is going down.
- Speaker #1
Oh, yeah, totally.
- Speaker #0
Your emotions are telling you to sell, sell, sell.
- Speaker #1
Get out, get out, get out now.
- Speaker #0
But this strategy says no. So stick with the plan, stick with the rules.
- Speaker #1
Trust the process.
- Speaker #0
Okay. So we've got a pretty good grasp of volatility clustering and how the moving average helps us manage it. But what about the psychology of actually following this strategy?
- Speaker #1
Yeah, that's an important point.
- Speaker #0
I mean, it seems like it would go against some of our natural instincts as investors.
- Speaker #1
It does. Yeah. Our brains are wired to seek pleasure and avoid pain. And when the market is going down, that pain is very real.
- Speaker #0
It is. So how do we develop the discipline to actually stick with this, especially when it feels like the wrong thing to do?
- Speaker #1
It takes practice and a commitment to the process. Okay. And it's important to remember, this strategy is based on extensive research and backtesting. It's not just some random idea.
- Speaker #0
Right. It's got some data behind it.
- Speaker #1
It's designed to work over the long term, not to chase short-term gains. Right. So you've got to trust the process and focus on the bigger picture.
- Speaker #0
So you're saying it's okay if we miss out on some of those short-term rallies?
- Speaker #1
Exactly. Because the goal here is to avoid those big losses that can really set you back.
- Speaker #0
So having a long-term mindset is key here.
- Speaker #1
Absolutely. The market will always have its ups and downs, but trends tend to persist over time. And that's what this strategy is designed to capture.
- Speaker #0
Okay. So we've covered the core strategy, explored some of its variations, and even touched on the psychology of trend following. But what about the practical stuff? Things like... taxes and trading costs.
- Speaker #1
Those are important factors to consider, for sure.
- Speaker #0
Right. I mean, those are things that real world traders have to deal with. Yeah,
- Speaker #1
you can't ignore them.
- Speaker #0
No. So let's start with taxes. I mean, with all that buying and selling, it seems like there's got to be some tax implications there.
- Speaker #1
Yeah, you'd think so.
- Speaker #0
So is this a strategy that's going to give you a big tax bill every year?
- Speaker #1
Well, it's actually might be a little more tax efficient than you'd expect.
- Speaker #0
Oh, OK. How so?
- Speaker #1
Well, remember, you're selling. when an asset drops below its moving average, which often means you're taking a loss. Right. And those losses can be used to offset gains in your portfolio.
- Speaker #0
Okay. So we're talking about capital losses.
- Speaker #1
Exactly. And that can potentially lower your overall tax bill.
- Speaker #0
So those losses aren't just paper losses. They can actually work to your advantage come tax time.
- Speaker #1
Right.
- Speaker #0
That's a nice little bonus.
- Speaker #1
Yeah. And here's another thing. Because you're often riding trends higher for a while, a lot of your gains might end up being long-term capital gains. Right. And those are usually taxed at a lower rate than short-term gains.
- Speaker #0
So it's not just a performance edge. There might be a tax advantage too.
- Speaker #1
Potentially,
- Speaker #0
yeah. All right, so we've got taxes covered. But what about trading costs? I mean, all that buying and selling, the commissions have got to add up, don't they?
- Speaker #1
It's a good point. And it would be a concern if this were a high frequency trading strategy where you're making tons of trades every day. Right. But it's not. The average turnover for this kind of portfolio is actually pretty low.
- Speaker #0
OK. How low are we talking?
- Speaker #1
Like three or four round trip trades per year for the entire portfolio.
- Speaker #0
Wow. That's way less than I expected.
- Speaker #1
Yeah. It's not as active as you might think. And with all the low-cost brokers out there these days, commissions are much less of a burden than they used to be.
- Speaker #0
That's true. Okay, so we've tackled taxes and trading costs. But let's talk about the logistics of actually managing this kind of portfolio. Keeping track of all those moving averages for all those different assets, that sounds like a lot to juggle.
- Speaker #1
It can be, yeah. There are a lot of moving parts. But the good news is there are tools and resources that can help you stay organized.
- Speaker #0
Okay, like what?
- Speaker #1
Well, you could use a spreadsheet. If you're comfortable with that kind of thing, you can set up formulas to calculate the moving averages for each asset.
- Speaker #0
I'm not a spreadsheet wizard. Are there any other options?
- Speaker #1
Of course. There are charting platforms that make it easy to plot the price charts and moving averages of your holdings.
- Speaker #0
Oh, so you can visually see when those buy and sell signals are triggered.
- Speaker #1
Exactly. And if you prefer a more hands-off approach, there are portfolio tracking websites and apps that can do a lot of the heavy lifting for you. They automatically update your holdings, calculate returns, and some even alert you when it's time to make a trade.
- Speaker #0
So whether you're a do-it-yourselfer or prefer things more automated, there are tools out there to help.
- Speaker #1
Absolutely. It's all about finding what works for you.
- Speaker #0
Okay, so we've covered some of the practical considerations, but let's take a step back and think about the bigger picture. What does this research tell us about markets, about how investors behave?
- Speaker #1
It reminds us that markets aren't always perfectly rational. They're driven by emotions, fear and greed, which often lead to those trends we've been talking about.
- Speaker #0
That makes sense.
- Speaker #1
And this trend following strategy is really about exploiting those patterns. It's not about predicting the future. It's about recognizing those trends exist and writing them.
- Speaker #0
So instead of trying to outsmart the market, we're letting the market guide our decisions.
- Speaker #1
Exactly. We're not trying to time the market perfectly. We're just following its lead.
- Speaker #0
And this research suggests that can be a pretty effective approach.
- Speaker #1
It can be, yeah. And it also highlights how powerful simple rule-based strategies can be. We don't need some super complicated algorithm to be successful. Sometimes the best approach is the most straightforward. It's about discipline and patience.
- Speaker #0
And trust.
- Speaker #1
And trust, right. Trusting the process, even when it feels uncomfortable.
- Speaker #0
Sticking to the plan, even when you're tempted to do something else.
- Speaker #1
Exactly. And that's often the hardest part. But the research suggests it can be incredibly rewarding over the long run.
- Speaker #0
It's been a fascinating deep dive into asset class trend following. We've gone from the basic rules to the potential benefits and even covered some of the practical stuff you need to think about.
- Speaker #1
It's a strategy with a lot of flexibility and the research suggests it can be really effective. Hopefully our listeners will walk away with some new insights and maybe even consider incorporating these principles into their own investing.
- Speaker #0
That's what we hope for. Thank you for tuning in to Papers with Backtest podcast. We hope today's episode gave you some useful insights. Join us next time as we break down more research. And for more papers and backtests, find us at https.paperswithbacktests.com. Happy trading.
