Simple, quantitative trend following can help you avoid the drawdowns and black swans of the market… considering you can stick to the rules. This is highly noticeable when you look at a chart showing the growth of $10,000, especially over any time period including the ‘lost decade‘ of the $2,000s.
Take a look at the chart below which shows a trend following strategy using Vanguards Aggressive Growth Life Strategy Mutual Fund (VASGX – 80/20) and then just a buy and hold of the same fund. Here are the rules from the backtest using Portfolio Visualizer:
1) If 10m Total Return > SMA 10m; invest in VASGX
2) If 10m Total Return < SMA 10m; invest in VBMFX
3) Trade at next close price (this lowers the return a bit and ‘assumes the worst’)
Clearly the trend following strategy outperforms over this period from Jan 1 1996 through March 31 2017. Through this time period, the market experienced two big drops which gives way to awesome performance for the initial investment in a trend following investment strategy. But trend following doesn’t out perform over everytime period. When the market is ripping higher, the trend following strategy will lag. Like wise, the start of the high rips are when market is in the pits. Take a look at what would’ve happened had the initial investment been made Jan 1 2009.
Investments made in the buy & hold, near the bottom of the great recession, would’ve outperformed the trend following strategy by over 3% per year. Considering taxes it would, probably be over 4%. Clearly trend following isn’t the holy grail of investing.
Lets Get Real
No one just invests one lump sum in their life time. Investing should be done consistently over time, a little bit today, a little bit next week or month — dollar cost averaging. That bring up the question: what does dollar cost averaging look like on a trend following strategy? Answering that question is rather difficult as their is no simple tool for back-testing a trend following strategy and making contributions to strategy, so I decided to do it by hand. That meant lots of clicks.
First though, lets start with buy & hold. If you invested $10,000 on Jan 1 1996 and then $10,000 on the first of every year after that, until the end of March 2017, here’s what your portfolio would look like:
Total portfolio value is $468,228 with an internal rate of return (IRR) of 6.14%. Not too Shabby. What if we did the same thing for the trend following strategy: invest $10,000 every year since 1996? Unfortunately I don’t have a cool chart of total portfolio to show you, but you would ultimately end up with a total portfolio value of $607,968.00 with an IRR near 8% (not calculated). Trend following outperforms over this time period. In lieu of this out performance it is import to note that after taxes your total return will likely be the same. Based on calculations I’ve done previously, you would lose about 1.7% annually to taxes (assumes 33% tax rate)… that tax hair cut would put you right near the buy & hold strategy. Below you will see the value of each $10,000 annual investment and then the sum that was arrived at. Link to the excel work book is further below.
Excel File From Pic Above: Trend following DCA back test