In this week’s episode of the Systematic Investor podcast series, Mark Rzepczynski spoke about the long-standing (and quite controversial) question of whether Trend Following and Momentum investing is the same thing.
To those of you who are in a hurry, here is the answer to this question straight away. Trend Following and Momentum investing are NOT the same things.
To everyone else who has a few minutes to spare and would like to know why these two investment approaches are different, you may want to stick around for a little longer. Let’s start by laying down some groundwork.
In academia, there are two well-known approaches to analyzing financial data. Researchers can look at time series data and study a single financial instrument across its own history. A good example of this would be analyzing the historical price data of a single stock, for example, Microsoft. What researchers care about in this scenario is whether Microsoft’s price went up or down during the time period in question. This is an example of an absolute type of momentum.
The alternative approach is when researchers perform a cross-sectional analysis and study the difference between similar assets at a specific point in time. For example, they may be interested in how Microsoft‘s YTD returns compare to those of Google, Amazon, IBM, etc. on a specific day of the year. This is an example of a relative type of momentum. Figure 1 illustrates the difference between time series and cross-sectional data analysis.
Figure 1: The difference between time series and cross-sectional analysis
Now that we appreciate the difference between time series and cross-sectional analysis, it is easier to understand why Trend Following and Momentum Investing are inherently different.
Momentum investing is a relative momentum strategy that is best applied among similar assets like equities. Momentum strategies perform a cross-section analysis of the investment universe and rank order its constituents based on relative performance to one another over a certain period of time. After that, momentum strategies express these rankings by building a portfolio of two legs – a long leg comprised of the top-ranked assets and a short leg comprised of the bottom-ranked assets.
Importantly, because momentum strategies are based on relative momentum, they remain invested in their long and short legs regardless of the prevailing market environment (i.e., irrespective of whether markets are falling or rising). Thus, momentum strategies deliver their outperformance on the premise of top outperformers continuing to beat top underperformers.
Trend Following, on the other hand, is an absolute momentum strategy that, as the listeners of our podcast series well know, works great across a wide range of different asset classes like bonds, equities, and commodities.
Trend Following strategies perform a time series analysis – they are not interested in how different assets perform relative to each other but whether or not these assets are in an uptrend or a downtrend. Trend Following systems actively use long and short positions but, unlike traditional long-short momentum strategies, are not invested at all times. Put more simply, Trend Following’s overall exposure is not fixed but depends on the “trendiness” of the current market environment.
So, there you have it – the answer to the question of whether or not Trend Following and Momentum strategies are the same things. We warmly invite you to tune into this week’s episode and listen to Mark, who not only touched upon the issue of Momentum vs. Trend Following investing but also discussed many other interesting topics.
We would also suggest you tune into this week’s episode of the Systematic Investor series with Mark who touched upon many exciting topics including the issue described above.
As usual, we promise, it will be a good investment of your time