The Limiting Case Of Equity Trend-following is Passive Investing

Many of us who were trend-followers in the 1990s find the current notion of equity trend-following sort of peculiar, if not amusing, due to hindsight bias effect.

Trend-following in the 1980s and 1990s meant different things as compared to the description found today in articles and books on systematic trading. The basic difference was the lookback window used in timing indicators, in most cases moving averages. To make a long story short, in the last 30 years, the lookback window started increasing steadily due to inability of the market to provide profits to a crowded trading style. When I started trend-following equities in the 1990s I was using a 25-day moving average. Nowadays people talk about 200 days or 10 months. Why not using then a 100-month or 400-month moving average? The answer is that the lookback period is determined via hindsight bias: people look at backtests on historical data and select the moving average that would have performed best in timing the market. This is of course data-mining and anyone who is doing it is being fooled by it. Unfortunately, the list of fooled includes not only amateur system traders but also well-known authors and university professors. And the list if relatively long.

I will not go into the details of the causes of the gradual increase in required lookback window for trend-following as this was already done in past articles, for example in this one.  Jim Simons has summarized this nicely in a TED interview as follows:

Trend-following would have been great in the ’60s, and it was sort of OK in the ’70s. By the ’80s, it wasn’t.

What does Jim Simons understand that scores of traders and authors of papers do not? I will attempt to summarize it as follows:

When the lookback window is increased beyond a certain value, then trend-following performance is statistically indistinguishable from passive investing performance.

In fact, the limiting case of trend-following is passive buy and hold for large lookback periods. This is shown in the monthly S&P 500 chart below:

As the period increases from the popular 10-month, the portion of the price series displaced above the moving average series increases. For a 400-month average, the whole S&P 500 price series lies above the moving average series. Therefore, for a 400-month rule, trend-following is equivalent to passive investing. Or in other words,

A passive investor is also a trend-follower

in the sense of some suitable moving average trading rule.

The trend-follower who suffers from hindsight bias will probably object to the above analysis. I will accept the objection as a starting point of a debate if the trend-follower presents a valid argument of where exactly a moving average rule stops being a trend-following market-timing strategy and becomes a passive strategy. Actually, this can only be argued in hindsight. In the aftermath of prolonged sideways market activity, the 10-month rule will lose its prominent place in favor of a longer period rule that would absorb the whipsaw and related losses. But this will only take place in hindsight.

When I hear about people talking about the merits of trend-following I become very skeptical, especially given that this is a crowded space with no barrier to entry. I have talked about these facts in a recent article. Funds and investors should get prepared as the market can no longer accommodate too many trend-following strategies after QE ended. A return to idiosyncratic alpha will be a must for those that will survive.

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Charting and backtesting program: Amibroker

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