Unpredictable Economic Times & Trend Following: A Match Made in Heaven

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• Nobody truly knows what the future holds — even the prognosticators on 24-hour business news networks. However, investors crave cause-and-effect analysis of economic factors like government policies and price-to-earnings ratios.
• Nick Baltas, a managing director at Goldman Sachs, is a proponent of “trend following” as a trading strategy, which relies on predetermined rules and objective data instead of forecasts, emotions and instincts.
• Nick explains why trend following is an especially effective strategy regardless of whether current market conditions are bearish or bullish.

Despite the prognostications on CNBC and Bloomberg, nobody can predict the future. But most investors think analyzing economic projections, government policies and corporate balance sheets will help them foresee market direction and underpin their trading decisions. 

Nick Baltas, a managing director and head of R&D, cross-asset delta-one and commodity systematic trading strategies at Goldman Sachs, thinks differently. He’s a proponent of a particular strategy known as “trend following,” which eschews the prediction game in favor of rules and objective data. It takes emotion and instinct out of the equation. 

An investment strategy utilized for many years (especially among futures and commodities traders), trend following is rarely taught in schools and is definitely not a hot topic on “Squawk Box.” That’s because the practice requires restraint, patience and composure in times of upheaval. 

Nick invokes the advice we heard recently from Annie Duke: “You need to be confident about quitting at times,” he says. 

How, exactly? That’s where “systematic” comes in: This style of trading depends on preset entry and exit rules, strict risk management that considers current market prices, equity level in the investor’s account and current market volatility.

“Trend following is not anticipatory,” Nick explains. “We’re just expecting things to move, and should they move and confirm a direction, then we’re going to deploy the exposure.” 

My co-host Rob Carver and I welcomed Nick to a Top Traders Unplugged episode to discuss systematic investment strategies, aka “trend following” or “trend trading”; why this approach is performing so well in today’s challenging economic landscape; and why it’s becoming an essential part of every investment portfolio.  

Why is [x] trending? It doesn’t matter

To better understand trend following, it’s useful to consider that making money by trading requires trends. No matter what school of thought informs our decisions, if prices don’t trend upward after buying assets, we’re not able to sell them at higher prices. And the “following” part of this strategy is crucial: Trend followers do not innovate trends or adopt them early — they wait for the trend to establish itself, then trade in that direction. They make decisions based solely on the current and historical price of a given asset.

Trends themselves “cannot create a downturn,” says Nick. “[They’re] purely exogenous.” 

In fact, understanding trend-following strategies doesn’t require us to talk about the causes of trends. All we need to consider is what is happening now, based on our predetermined rules. 

“It's the same thing a stop-loss rule would do,” he notes. “So there’s some form of risk management that comes into play, even for long-only investors, that will start reducing the exposure to whatever asset they hold.”

What does trend following look like (and why isn’t it more popular)?

Michael Covel, one of the best-known popularizers of trend following, says that we can answer the following five questions and, voilà — we have a trend following trading system:

• What market do you buy or sell at any time?
• How much of a market do you buy or sell at any time?
• When do you buy or sell a market?
• When do you get out of a losing position?
• When do you get out of a winning position?

Arguably, it’s much simpler than attempting to understand the complexity of, say, oil prices, cryptocurrencies or corporate earnings forecasts. Trend following relies on objective data — market price histories — and the strategy isn’t restricted to a single market or instrument.  

But cause-and-effect explanations are easier to understand — and, of course, the media thrives on daily “buy/hold” drama and 24-hour news cycles. Systematic trading is decidedly drama-free.

When trend following didn’t work (and why)

With a Ph.D. in finance and a visiting researcher position at Imperial College Business School (his alma mater), Nick’s approach to systematic investing strategies is academic as well as practical. 

In 2016’s “Trend-Following, Risk-Parity and the Influence of Correlations,” a chapter in the book “Risk-Based and Factor Investing,” he writes:

Trend-following strategies take long positions in assets with positive past returns and short positions in assets with negative past returns. They are typically constructed using futures contracts across all asset classes, with weights that are inversely proportional to volatility, and have historically exhibited great diversification features, especially during dramatic market downturns. 

However, following an impressive performance in 2008, the trend-following strategy has failed to generate strong returns in the post-crisis period, 2009-2013.

With this work, Nick’s aim was to crunch the numbers in an effort to understand exactly what happened. Essentially, his thesis is that the period after the Great Recession was characterized by dramatic increases in the correlations between different asset classes — and the volatility-parity weighting scheme widely used by trend followers was suboptimal under such conditions. 

A risk-parity weighting scheme works better, but it’s conventionally formulated for long-only portfolios. Nick’s paper includes a new scheme that allows for short positions as well, a feature necessary for a trend-following portfolio. 

What about crowding?

Trend followers scale either by volatility or by risk. So what if, in a down market, the price of an asset drops — and is accompanied by a spike in volatility? Does that mean trend traders’ activity will push prices down? Not necessarily, says Nick.

“What you’re actually doing is reducing your gross, so if anything, not only do you not intensify the down move, you’re actually acting as a support to the market.” 

That’s not to say that crowding (the tendency of investors to gravitate toward a similar set of strategies or assets) can’t have an impact. 

Nick argues that we can look at the concept in a number of different ways. At the industry level, crowding might be part of “how margin and leverage can affect the system … [but] that’s more of a liquidity crisis in fire sales,” he says. 

From the perspective of a manager, crowding can affect how best to deploy new capital: “whether it’s time to deploy that capital to [be] more liquid, which in the grand scheme of things is lower expected return opportunity, and therefore, being in the position of having to split [one’s] exposure and possibly have diminishing returns to scale.”

But we can also look at the phenomenon of crowding in isolation to understand how the mechanics of a particular strategy react “in a period that is experiencing inflows.” 

Nick notes that the impact of crowding “is not necessarily a negative impact — if anything, any systematic premium almost requires systematic flows into it to justify the existence in the presence of it. If I do something and nobody else does it, guess what? It’s not going to be rewarded in one way or the other.”

Trend following is tailor-made for uncertain economic times

Nick’s most recent work, published in the Financial Times (“Inflation Is the Friend of Your Trend,” July 2022) explains why trend following has been a winning strategy so far this year:

… fuelled by broader herding and geopolitical tensions, gradual moves became suddenly stronger. Risk management tactics only strengthened the trends, such as when stop-loss orders were triggered in falling markets or when commodity consumers entered long futures positions to hedge soaring prices. … The point is [not] to make any claim that trend-following strategies constitute a direct inflation hedge. 

Rather, it is to argue that inflationary regimes mechanically give rise to macroeconomic uncertainty, debates around transient and steady states and central bank action (or lack thereof). All these dynamics are ingredients for a price-trendy environment; inflation is a friend of your trend.

Nick thinks this reasoning still applies to the economic forces at play now, as we head into December. 

“Any multi-asset, diversified portfolio this year is about 20% down, assuming a 10-vol annualized,” he says. 

“It is really, really hard, Nick continues. “By all means, the inflation dynamics suggest that had you done short rates, short equities, long commodities, give or take — given also the historical relationship with all the classes due to inflation — you would have done amazingly well to date. But … is that really a sustainable inflation hedge? You cannot maintain that portfolio forever.”

Moving forward, Nick posits that trend following “will require more active, more dynamic allocation schemes,” and that as a strategy, “it will become a way to dynamically adjust exposures as a function of the recent move.” 

Theologian Martin Luther once said, “Nothing in the world causes so much misery as uncertainty.” But he clearly hadn’t tried systematic investing.

“Uncertainty, in my view, is fundamental for trends to exist,” says Nick.

In these unprecedented times, we might as well embrace the unpredictable and follow the trends.

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This is based on an episode of Top Traders Unplugged, a bi-weekly podcast with the most interesting and experienced investors, economists, traders and thought leaders in the world. Subscribe on your preferred podcast platform so that you don’t miss out on future episodes.