My trend following strategy delivered a net return after fees of 1.6% during 2021, while a 60/40 portfolio was up about 14% and the S&P 500 was up 26.9%. Underperforming the broad market or benchmark portfolios can be very frustrating to investors, but as we've said many times in this blog, it is better to deal with frustration then devastation. Devastation comes from watching your capital evaporate during a bear market, panic selling after the damage has been done, and then not being able to participate in the eventual recovery out of fear that more losses could occur. The Buy & Hold approach is truly devastating at times to investor's confidence and their retirement plans.
The frustration of our chosen investment approach can somewhat be mitigated by examining the goals of the strategy and whether those goals continue to be met. We are never focused on outperforming the broad market or other benchmarks in a specific time period like months, quarters, or calendar years. The primary goal (#1) of our strategy is to deliver good returns over time, especially over full market cycles, while avoiding the large losses that are seen in bear markets.
Our other goals are to (#2) deliver higher risk-adjusted returns than the S&P or reasonable benchmarks and to (#3) beat the S&P500 over full market cycles. A full market cycle includes a bull market and a bear market. You have to include a bear market in the comparison to the S&P or it is not a reasonable comparison, since most tactical strategies like ours deliver a significant amount of outperformance when they avoid the damage of bear markets. That cannot be overlooked. Of course, if you think we won't have any more bear markets in the U.S. you might as well stop reading now, and good luck to you!
Related to goal #1 is that we want to invest in a way that never causes a client to panic sell for suffering large losses. Advisors that use the Buy & Hold approach to investing will put their clients in that situation multiple times throughout their careers. We avoid that scenario by focusing on risk management and downside protection.
Below is a chart of the Nasdaq Composite index for the year, shaded green when my trend model was invested and red when it was defensive. The Nasdaq was up 21.4% during the year. The blue lines break the year into quarters and the net return are shown for each period. From this chart you can see our model getting invested after an uptrend begins, only to be stopped out (sometimes quickly) when the market pulled back. Losing money in defensive positions during Q1 and multiple whipsaw trades in Q3 attributed to most of the underperformance.
Many will look at the year-end number of the major index returns and conclude that the market moved straight up all year. This was definitely not the case. The Nasdaq had several pullbacks between 6-8% and was in a full correction, down more than 10%, in March.
Trend following works best when the market trends, and during 2021 the market never had a sustained uptrend (or downtrend, for that matter). Thankfully, we know from our research that the U.S. equity markets do exhibit many periods of trend and our belief is that our strategy will be able to capitalize on those periods, all while avoiding major drawdowns.
Looking beyond just the one year allows us to see if we are still achieving our goals in terms of returns. Over the three-year period, trend has had average annual returns of 18.7%, versus the 60/40 portfolio of 17.3%, and over the five-year period of 14% versus the 60/40 portfolio of 12.2%. Keep in mind that the three-year and five-year periods take into account the underperformance of 2021. The 60/40 is a more appropriate benchmark based on the risk of our strategy.
Sometimes a single strategy is hard to stick with even if it is meeting the stated goals, because it is hard for investors to not compare it to the S&P and they often get frustrated if the relative performance to the S&P lags by a lot. Investors often chase returns and may go elsewhere when they see a strategy underperform. No strategy or investing approach can beat the S&P500 over every timeframe...that seems to be what people expect, but it doesn't exist.
Dance with the Trend,
Greg Morris
