Protecting the Downside of Trend When It's Not Your Friend

Abstract

Simple trend-following strategies have been documented as cost-effective, transparent alternatives to the hedge-fund style Managed Futures strategies. While largely capturing the returns of the Managed Futures industry, those simple strategies may periodically suffer significant losses due to over-simplified trend signals and under-diversified portfolio construction. In this article, the authors show that trend-following strategies with moderate sophistication and better diversification can significantly reduce the downside risk of simple trend-following strategies without sacrificing much upside potential. The authors therefore recommend investors who seek the benefits of cost-effective trend-following strategies to consider adding reasonable complexity to the strategies.

Keywords: trend-following, Managed Futures, CTA, hedge funds, portfolio construction, risk management

JEL Classification: G02, G11, G12, G13, G14, G23