Where Do Trend-Following Profits Come From?

Before elevating trend-following and momentum in general to the status of a factor, this question must be answered: where do trend-following profits come from? Obviously, part of momentum literature ignores this important question.

There are no profits in the markets unless there are counterparties that are willing to lose or creation of new wealth in the case of equity markets.

Anyone in the fund management or trading business should understand where profits come from for the investment or trading method employed. Apparently, some rely on historical analysis, a dangerous practice that is based on backtesting and generates many forms of biases, to argue for this or that trading method is profitable without understanding the sources of profits.

The primary problem of backtesting is that it does not affect market prices because the models tested are not real market participants. I explain this in my out-of-print book Profitability And Systematic Trading (2008.)

Some even write papers about two centuries of trend-following without respecting the fact that this style of trading was first mentioned in the 1949 article Fashions in Forecasting by Australian hedge fund pioneer Alfred Winslow Jones.  Before that, in 1935, H. M. Gartley had made references to moving averages and their use for trading in his book Profits in the Stock Market and pioneer trader William Dunnigan had published Trading With The Trend in 1934. But the official acceptance of trend-following came with the article by Richard Dochian, Trend-Following Methods in 1957. Note that Dochian used a 5-20 day moving average rule. This is important to realize because much of what is called trend-following nowadays is far from the ideas of those pioneers. Simply because 20 days and 200 days can be the periods of a moving average this does not mean that in both cases trend-following means the same thing. This is discussed in more detail in this article where I also refer to the TED interview of J. Simons where he basically calls trend-following dead.

Systematic trend-following appeared in the late 1960 and became popular in the early 1980s with the advent of Commodity Trading Advisor (CTA) programs. Before that, it was used by few traders and for this reason it was not a factor influencing market behavior. Any long-term backtests before the 1970s commit the error of testing a trading strategy that was not being widely used. This is important because if a strategy is being used by many professionals, then it affects market dynamics. This is totally neglected by the naive backtests that attempt to quantify trend-following profits centuries ago. Note that trends and trend-following are not the same thing. Anyone equating the two is naive and has no skin-in-the-game. Although trend-following requires trends, the existence of the latter is no guarantee that profits will be made since the former requires a strategy, which by the way did not exist before the mid 1900s.

 Where do trend-following profits come from?

Obviously, trend-following gains do not come from passive investors, they must come from other traders. As passive investing gains popularity, profit potential of trend traders decreases significantly. What amazes me is that many confuse fundamental economic factors, such as demand and supply, with trading. In trading a long position to follow an uptrend is made possible by the existence of enough counterparties that are willing to sell. At the exit point, selling a position established along an uptrend also requires a sufficient number of counterparties that are willing to buy what is sold.  In essence, profiting from trends requires counter-trend traders. I wonder why this is not understood by many who promote this trading method.

In commodity futures trading profits of trend-following in the early days came for hedgers and a large number of retail speculators who were undisciplined and traded randomly using untested methods, such as chart patterns and simple indicators. CTAs were rewarded for using systematic methods and exercising disciple at the expense of compulsive and emotional retail traders. As retail trader ruin rate increased, potential for profit decreased. For this reason it is not a surprise that CTAs have been unable to make any serious money in the last 12 years, as the chart below shows:

In fact, as shown in this article, in the last 12 years top 20 CTAs have realized less than 2% annually on the average. The main reason for this is that there are not enough uninformed and undisciplined counterparties to provide the profits, as in the 1980s and 1990s. Most retail traders use systematic strategies and have learned how to control risk. Anyone showing a long-term backtest and then claiming that trend-following is a profitable style is not in touch with reality but an unfortunate victim of hypothetical performance records. Usually authors of articles with no real skin-in-the-game commit this blunder.

The stock market has been even more interesting technically. In this article we discuss the inversion in autocorrelation from positive to negative in late 1990s and how this has affected trend-following in the equity markets.

After autocorrelation turned negative and momentum basically died in the equity markets, there were two major bear markets in a period of 8 years, the 2000 dot com top and the 2008 financial crisis top. Without assistance from central banks in the form of induced momentum, equity markets will collapse. Trend-followers in equity markets have realized large gains in the last eight years because of central banks acting as counterparties that are willing to lose money. This significant distortion and moral hazard are the result of failed economic policies but at the same time the effort to maintain uptrends in equity market has financed the lifestyle of fund managers while the customers believe the profits are secure.

In the equity markets there are not enough retail counterparties to provide profits to trend-followers at this point. Most retail traders who have survived are fairly sophisticated and use prudent risk and money management. Actually, these retailers try to profit from the mistakes of funds.

Before mid 1990s, there were not enough retail traders to provide profits to trend-followers and value investing dominated. Any analysis of trend-following and momentum factors before around 1970s is naive because had these traders been in the markets, they would have affected prices in ways we cannot know at this point. Note that this is not an issue of slippage but of changing market dynamics. Actually, when trend-following became popular, equity markets reacted by reversing autocorrelation. Had trend-following been used two hundred years ago, similar effects would have taken place.

Many authors of papers that include naive backtests of momentum and trend-following do not realize that the historical price path we see today is only one of many possible paths that could have been realized had the participation in the markets been different. Most of these authors do not have a good conception of probability and many have no skin-in-the-game. Yet, we all know that recognition comes from public relations and not from actual value of work in many cases.

Trend-following is in trouble nowadays because central banks are slowly pulling out of the markets before they are accused of persistent manipulation and retail traders have gotten more sophisticated. There are simply not enough counterparties willing to lose to trend-followers. The party is over, I think for good. Anyone looking at trend-following and momentum in general as factors is living in the past. The name of the game now is mean-reversion, statistical arbitrage, machine learning, HFT and other methods that may become known after many years, both mathematical but also of more esoteric nature. I know some people working on some of these esoteric methods in the sense that they are based on principles that are not recognized as scientific, at least at the present time.

To summarize, trend-following offered an edge during a period of time of about two decades where there were enough retail traders that could contribute to its profits. Lack of such counterparties in sufficient numbers affects trend-following profitability. This was the case before the 1970s and is also the case nowadays that trend-following is actually used.

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