Flavors of trend following.

There have been many inadequate definitions of “active management” by those in the business press.

Strategies that include actively managed mutual funds or an active sector-asset-allocation approach are certainly legitimate components of more robust active management overall best practices.

However, they are hardly the entire story, though one could easily get that impression from the media.

One might also think that the only meaningful question surrounding active management is “What has delivered a better return this year: passive indexed funds or actively managed funds?”

The press largely ignores the broad underpinnings of an actively managed portfolio approach: strategic diversification, risk management, the smoothing out of returns, avoiding large drawdowns, and delivering consistently positive performance to be compounded over time.

To achieve these objectives, active managers can employ a wide array of investment tools and strategies, including, yes, actively managed mutual funds and sector allocation strategies and rebalancing.

But they also may employ inverse funds, futures, derivatives, private equity, leveraged ETFs, and many alternative asset classes.

In between these two extremes of “plain vanilla” active management and some less-conventional tactics lay an abundance of other actively managed strategic alternatives.

There are certainly more “flavors” of trend-following strategies than varieties of Baskin-Robbins ice cream. But they all generally begin with a common premise: nothing is more important than price and its current direction.

As the name implies, the goal of a trend-following trading system is to stay in tune with the prevailing trend of the market at all times. It is said that one of the biggest benefits of such an approach is that price cannot diverge from itself. In short, this means that while many indicators (such as economic, monetary, market leadership, and/or momentum indicators) can diverge from the trend of the market, a trend cannot diverge from itself.

Advisors employing trend-following strategies may utilize virtually any asset class or time frame, although trend-following strategies are most commonly associated with the equity markets. Trend-following has sometimes been called the complete antithesis of value or fundamental investing, as strategies seek out sustained price direction or momentum as their primary driver. The key is early and confirmed identification of a change in trend and hopping aboard when given the correct signal.

Successful trend-followers will readily admit that they might not catch the exact bottoms of moves for a long position or exit at tops, but have as a goal the capturing of a majority of a trending move. In today’s modern environment, most trend-following strategies utilize sophisticated computer models and indicators that attempt to be on the right side of the market index being traded when big or intermediate-term moves occur.

Having a trend-following component of a diversified, risk-oriented active management approach can provide several important and broad benefits, especially versus passive buy-and-hold strategies:

• Adding a tactical strategy to a portfolio seeks to improve the risk-adjusted returns of the portfolio by reducing drawdown during market sell-offs and increasing participation in market rallies. The goal is a smoother ride to a superior outcome over the entire market cycle, through the bull market and inevitable bear alike.
• As stock markets go through various phases of high and low volatility, active managers can employ strategies that seek to take advantage of price changes regardless of the volatility of the market environment.
• While some trend-following strategies may move to the safety of money-market funds when in defensive mode, others may utilize inverse funds with the goal of profiting even when their specific market is experiencing a pronounced downtrend.
• Other trend-following strategies may employ leveraged funds to have even greater market participation when their models signal particularly favorable market conditions (whether to the upside or downside).

Trend-following strategies have their ardent supporters and some detractors, as is the case with just about any investment thesis. “The trend is your friend,” however, like many other hallowed Wall Street sayings, has a strong basis in historical fact, academic research, and rigorous backtesting. Tactical trend-following strategies can be especially effective when followed with today’s sophisticated models and strict adherence to rules and discipline, and most importantly, as just one component of an overall actively managed approach.

The opinions expressed in this article are those of the author and do not necessarily represent the views of Proactive Advisor Magazine. These opinions are presented for educational purposes only.