Looking Back on Trend Following – Part 1
The conventional wisdom is that the well-known managed futures indices overwhelmingly comprise managers following trend-following strategies. It’s also no secret that the indices have had a tough time of late. (Maybe that’s being too kind, with the 12-month return of the SG CTA Index currently at -6%.)
So why has trend-following been so bad? Just saying that “trend-following hasn’t performed well” is a pretty lame answer. Personally, I like to know the root cause of things. Moreover, if a root cause can be quantified, I like it even better.
I would like to have a quantitative measure that explains which markets were good for trend-followers and which markets were bad. If I can answer that question, then I should be able to quantitatively explain why trend-following was good or bad in different periods and even why one trend-follower may have done well while another one suffered.
Trend-Following Index Types
The standard way of explaining trend-following performance is to refer to one of the trend-following indices.
There are essentially two types of trend-following index. The first type aggregates the performance of trend-following CTAs. The SocGen Trend Subindex is an example of this type of index. The second type synthesizes an index by aggregating the performance of one or more relatively simple trend-following trading models. The SocGen Trend Indicator is an example of this second type of index. (On the SG Prime Services Indices page, look under Daily Indices for links to these indices.)
Neither of these types of index attempt to directly relate trend-following performance to price action. In both cases, there are trading models that translate the price action into a return stream before it is included in the index. Rather than relying on an intermediate step, I want an indicator that will attempt to directly measure the “quality” of price action for trend-following.
The Trend Ratio
The idea behind the Trend Ratio (TR) is to calculate a ratio between the net price movement (i.e. the return potential) and the gross price movement (i.e. “noise”) during a given period in a given market. Refer to the figure below for a graphical representation.
Calculation of Trend Ratio
Trend Ratio = Net Price Movement / Gross Price Movement
The Trend Ratio is a risk-adjusted return measure. The return part of the ratio is the net price movement over the period. This is the amount of profit a trend follower could have garnered if he had entered a position at the beginning and exited the position at the end of the period. The risk part of the ratio is the gross price movement over the period. This is the sum of all the ups and downs the trend follower had to suffer through before closing the position.
As with all risk-adjusted return measures, higher values of TR are better than lower values. A value of 1 (one) means it was a perfect trend, moving only in one direction and never backtracking. A value of 0 (zero) means the market was perfectly non-trending, with no net price movement.
Measuring Trend Quality
Now we have something we can use to quantitatively measure the quality of trending markets. The charts below show the result of applying TR to two different markets, Crude Oil and Euro currency. In both cases, TR is calculated on daily prices with a lookback period of 262 days (approximately one year of trading), and then smoothed and displayed on a weekly continuation chart for clarity. The blue histograms below the prices show the values of TR.
Crude Oil with Trend Ratio
The results look promising. Values of TR grew as the collapse in oil prices gathered momentum in late 2014. As the downtrend failed and reversed, TR fell almost to zero. Early 2017 has seen some recovery in the quality of the trend, but nothing like two years earlier. Remember that the lookback period is one year, so each value of TR represents the quality of the trend over the previous year.
Euro Currency with Trend Ratio
The chart of the Euro looks similar. The Euro collapsed in value from Q1 2014 to Q1 2015 in a very nice trend, resulting in sharply increasing TR. Since then, there has been very little long-term trending action in this market and TR has fallen back to almost zero. Again, the lookback period is one year.
The Trend Ratio is an attempt to relate trend-following performance directly to price action. I’ve shown how to calculate the Trend Ratio and displayed some evidence that it might do what I want it to do. TR seems to be able to identify periods during which specific markets were good for trend-following strategies.
In the next post in this series, I’ll calculate TR for a portfolio of futures markets and compare it to the performance of trend-following CTAs over the same period. If my hypothesis is correct, there should be a high correlation between TR and trend-following strategies.