Hortz: What are the specific benefits of a trend following approach?
Robinson: Oh wow, where do I start? I could probably write a book on this subject alone.
First, the benefit that usually resonates best with an advisor’s clients is that trend following is a reliable way to protect against large market declines. This preserves capital and allows for compounding to continue at a higher base.
But it’s also an inherently tax-friendly approach to investing because it sells losses quickly and holds winning positions indefinitely if the trend doesn’t change. In our trend-followed portfolios, for example, during most environments our process will allow us to produce a tax-aware outcome. This is due to our systems being designed to produce tax alpha by harvesting short-term losses and maintaining exposure to winning positions.
Circling back to the anxiety many advisors are feeling about the current market environment, another reason trend following can be so impactful is because it allows you to objectively stay invested longer than your emotions alone would have allowed.
Lastly, trend following works broadly across asset classes, which allows for robust diversification. Trend following isn’t limited in the way a factor-based approach or other constrained methodology would be. Rather, trend-following systems can be applied to all asset classes, to passive investment vehicles, and even to individual stocks. Our approach, for example, is applied to the full world allocation, as well as single stocks.
Hortz: How does trend following compare to other defensive strategies?
Robinson: I’d caution against labeling trend following as a defensive strategy, given its ability to adapt in both rising and falling market environments. The persistent upside capture is an often-overlooked feature to trend following.
With that said, many defensive strategies prioritize risk management to such an extreme level that advisors end up “overpaying” for the downside protection, either in terms of fees or opportunity cost. These strategies are akin to driving your car with the emergency brake engaged. They may do a great job of slowing down losses, but the cost or drag on performance is a serious limitation. Trend following is different because it is does not promote a permanently defensive position; it applies the brakes when conditions warrant but doesn’t start slowing down just because the light has been green for a while.
Here’s another way to think about it: While many traditional defensive strategies talk in terms of “defined outcomes,” trend followers talk in terms of “defined entries” and “defined exits.” In the end, that usually means trend-followed portfolios have more flexibility and freedom to be opportunistic and defensive.
Hortz: The way you describe trend following sounds rather simple—increase exposure when the trend is moving up, decrease exposure when the trend is moving down. Yet, esoteric and complex investment strategies have surged in popularity over the last nearly 13 years—and not just among defensively postured vehicles. How do you reconcile those two realities?
Robinson: Humans are drawn to complexity. I think it’s a gut versus head thing. The gut is instinctual—fight or flight—and is more likely to pursue simplicity. But the head is analytical and more likely to choose complexity. When presented with a few options, the head is wired to think the more complex one is probably the best choice, even if it’s just perceived complexity. Some of Dan Ariely’s research, for example, shows that the head might conclude that 34.0001% is better than 34%—that’s what I mean by perceived complexity.
Investing is an arena where the battle between gut and head is particularly brutal. Just like it’s hard to take emotions out of the investing process, it’s difficult to turn off that nagging voice from the analytical head (System 2 as Daniel Kahneman has called it) that investing can’t be simple to be effective.