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Insights: Play Ball! How Complete Is Your Investment Lineup?
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Play Ball! How Complete Is Your Investment Lineup?

The role that trend following can play on your roster

Major League Baseball fans will enjoy a historic start of the season this year. All 30 teams will take the field on Opening Day March 29, the earliest in league history.

But just like investing, it’s hard to predict who will still be standing at the end of the season.

A misunderstood trading style

Like pitching or hitting, there are many trading styles out there: value, growth, momentum, etc. But we’re huge fans of trend following. This trading style historically has produced outstanding long-term returns – but we admit it can be frustrating to watch in the short term. 

We think this stems from a misunderstanding of the nature of the trading strategy. Rather than “buy low, sell high,” trend following seeks to “buy high, sell higher.”

Mechanically, the strategy hunts for trends within a broad universe of assets, and then throws a lot of balls with the expectation that several will hit the strike zone. The strategy works best on a diversified basket of investments, so that one or two parts of the portfolio outperform when another isn’t working.

But it can be frustrating when trend following strings together a few months of losing before going on a winning streak. Sometimes it’s one big month, other times it can be sustained for several months. In technical terms, these acceptable losses have the potential to be functionally covered by the larger outlier months i.e. smaller negative returns with outlier returns coming more frequently on the upside.

If this sounds frustrating, consider long-only stocks. Stocks historically have produced smaller, consistently-positive returns with outlier returns coming more frequently on the downside.

A more balanced team

Match these two distribution curves together and you have the potential for a more robust, uncorrelated return stream.

In baseball terms, think of stocks like an high-on-base player. Someone who always draws walks, slaps singles and doubles, or leans into pitches – anything to get on base. They just happen to be injury-prone and can find themselves off the field, sometimes for inexplicable reasons.

Trend following is like a streaky hitter. They may start hot in April and May, only to cool off over the summer. This doesn’t make them bad players who aren’t valuable to the team; it just makes it a challenge to know when they’re going to heat back up. So, you keep them in the line-up because they excel at fielding their position, for example.  

When they heat back up, your patience can pay off. Hopefully it’s in the fall and they help carry the team to the World Series! In 2016, the Cubs’ Kris Bryant had a streaky season by some measures, yet ended up winning the National League MVP and helped the Cubs win their first world series since 1908. 

When it pays to be patient

A well-diversified, trend following strategy is the streaky hitter in your line-up. It productively contributes to the team by providing unmatched diversification from a broad opportunity set, even if they aren’t always on a hot streak.

So it comes down to this. Are you the kind of coach who’s willing to put up with some bad months in the regular season only to have your player win the MVP and carry your team to the World Series?  

Disclosures

Longboard Asset Management, LP (LAM) is registered as an investment advisor with the Securities and Exchange Commission (SEC) and only transacts business in states where it is properly registered, or is excluded or exempted from registration requirements. SEC registration does not constitute an endorsement of the firm by the Commission, nor does it indicate that the advisor has attained a particular level of skill or ability. LAM is also registered with the National Futures Association.

This website is limited to the dissemination of general information pertaining to its advisory services, together with access to additional investment-related information, publications and links. The information on this site does not involve the rendering of personalized investment advice. You should consult a professional advisor before using any of the information, pursuing any of the investment ideas or implementing any of the strategies presented. We believe the information we present is factual and up-to-date, but we do not guarantee its accuracy and you should not should not regard it as a complete and exhaustive analysis of the subjects we discuss. Our opinions reflect our judgment as of the date of publication and are subject to change.

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Definitions

Alternative investments: strategies that produce returns by taking risk other than equity and bond risk.

Bond: A debt security that shows ownership in a corporation or represents a claim in the corporation assets and earnings.

Correlation: a statistical measure of how two securities move in relation to each other.

Long: Buying an asset such as a stock, commodity or currency, with the expectation that the asset will rise in value.

Short: Buying an asset such as a stock, commodity or currency, with the expectation that the asset will decrease in value.

Stock: A security that shows ownership in a corporation or represents a claim in the corporation assets and earnings.

True diversifiers: investment strategies that have historically provided investors with at least 70% of the return of the traditional 60/40 stocks and bonds portfolios while having less than .30 bear correlation to traditional 60/40 stocks and bonds portfolios.