Trend Following: An Attractive Investment Strategy in Uncertain Markets

In the ever-evolving landscape of financial markets, uncertainty is a constant companion. Economic fluctuations, geopolitical events, and market sentiment can create an environment where predicting outcomes becomes increasingly challenging. In our view, trend following is an attractive investment strategy and particularly so amid this unpredictability. Its appeal lies in its simplicity, adaptability, and effectiveness in capturing market movements, especially during turbulent times.

1. Simplicity and Objectivity in a Complex World

One of the most significant advantages of trend following is its straightforward approach. The strategy is based on a simple premise: buy when prices are rising and sell when they are falling. This objectivity helps remove emotional biases from the investment process. In times of uncertainty, where emotional reactions can cloud judgment, trend following provides a systematic method to navigate the market. By relying on clear, predefined signals--such as moving averages or momentum indicators--investors can make decisions based on current market conditions rather than speculative predictions. See also our previous post "Remembering Daniel Kahneman".

2. Flexibility to Adapt to Changing Conditions

Market conditions can shift rapidly, especially during periods of uncertainty. Trend following excels in this regard due to its adaptability. Whether in a bull market, bear market, or a phase of high volatility, trend-following strategies will dynamically adjust to the prevailing conditions. This flexibility allows investors to pivot and stay aligned with market trends, with the strategy remaining relevant as circumstances evolve.

3. Capitalising on Emerging Trends Amidst Volatility

Volatility and uncertainty often lead to the emergence of strong trends. While other strategies might struggle with the noise of unpredictable markets, trend following focuses on capturing significant price movements that align with established trends. This ability to harness the power of volatile conditions enables trend followers to benefit from market inefficiencies and seize unexpected opportunities.

4. Built-In Risk Management for Uncertain Times

Effective risk management becomes paramount when navigating uncertainty. Trend-following strategies incorporate rigorous risk management practices, such as setting stop-loss orders. These mechanisms help limit potential losses and preserve capital, providing a buffer against unpredictable market movements. In times of heightened uncertainty, these tools are essential so that one adverse outcome does not derail the entire strategy.

5. Robust Historical Performance in Uncertain Markets

Historically, trend following strategies have demonstrated resilience in volatile and uncertain markets. The success of trend followers during periods of market upheaval underscores the strategy's effectiveness in navigating unpredictability. For instance, during financial crises or economic downturns, trend followers have often avoided significant losses and even capitalized on market declines. This empirical evidence highlights trend following's robustness and reliability, making it an attractive choice for investors facing uncertainty.

At our website and our YouTube channel you can view our video "Academic Research Support For Trend Following", in which ECCM's founder and CIO, Adam Havryliv, and Strategy Ambassador, Richard Brennan, talk more about the academic research on the effectiveness of trend following. 

Conclusion

In our view, trend following offers a compelling investment strategy due to its simplicity, adaptability, and potential for long-term gains, especially in uncertain market conditions. Its systematic approach reduces emotional bias, while built-in risk management ensures disciplined investing. Supported by historical success, in our view, trend following is an attractive strategy for navigating the complexities of financial markets - both seeking to capitalise on emerging trends and helping to protect against adverse movements.

At ECCM, our educational foundations are in finance and psychology. With extensive trading experience and long-term dedication to quantitative trading systems, we seek to provide our clients with our carefully developed approach to navigating the complexities and vagaries of markets.

Wholesale clients can find more information on ECCM and our flagship ECCM Systematic Trend Fund at our website and Australian Fund Monitors.

Globally, equity markets were positive in August. In the US, the S&P 500 rose +2.3%, the Nasdaq increased +0.7%, whilst in the UK, the FTSE was flat (+0.1%). In Australia, the All Ordinaries Accumulation Index increased +0.4%. The top performing sectors on the ASX were technology and gold, whilst energy was the worst performer.

Reporting season on the ASX saw the vast majority of listed companies report their results for the six months to 30 June. Overall, we viewed it as a solid reporting season, albeit with less strong earnings "beats" than in previous reporting seasons. Large cap stocks materially outperformed small/mid cap stocks (which the fund has a strong exposure to), with the ASX Small Ordinaries index falling -2.0%. Resources and mining services stocks underperformed as sentiment towards to Chinese economy continues to be weak. On the positive side, central banks both globally and in Australia appear on the cusp of cutting interest rates, which should be beneficial for economic growth, company earnings, and general investor sentiment towards equities. 

In bond markets, the US 10-year bond rate fell -28 basis points (bp) to close at 3.86%, whilst its Australian counterpart fell -15 bp to 3.97%. The driver of lower bond rates was data showing economic growth in the US to be slowing. In currencies, the A$/US$ appreciated +2.2 cents to close at US$0.68.

When you're chasing those enticing yields, high yield credit funds can seem like a golden ticket. They promise strong returns compared to other asset classes, which might make them look like the smarter choice. But before diving in, it's crucial to understand that not all fixed income assets are created equal. High returns come with their own set of risks, and knowing what those are can help you make more informed investment decisions.

The emergence of private credit funds

As banks cut back on corporate lending, private credit funds have become more popular, offering more competition and financing options. These funds aim to generate returns through various strategies, which require careful consideration. Key factors include:

• Sector Focus: Investing in different areas, like property construction or stable industries.
• Business Stage: Lending to well-established companies or distressed.
• Capital Structure: Positioning in the loan's repayment priority (e.g., first lien vs. unsecured).
• Loan Terms: Setting strict or flexible terms and borrower controls.

Understanding these aspects helps investors make informed decisions in this growing market.

Credit funds, including those focused on more speculative private credit and property construction loans, often attract investors with the promise of higher returns. These funds offer elevated interest rates because they invest in debt issued by companies with lower credit ratings. While the potential for greater income is appealing, it's essential to understand that these higher yields come with substantial risks.

Liquidity: The core concern

A hallmark characteristic of genuinely defensive assets is liquidity. Private credit funds often have lower liquidity due to long lock-up periods, longer lead-times for redemptions and infrequent fund trading windows. Since these funds tend to involve direct lending to organisations, the loans do not trade on exchanges, therefore the secondary market to recall or trade capital is extremely low and difficult. For example, during the early days of Covid-19 in March 2020, many fixed income funds, both traditional and alternative, raised sell spreads to effectively gate investor capital, showing that what seemed like a safe investment could be problematic in times of crisis.

Default Risk (Volatility): Compromising your hard earned capital

The primary risk associated with credit funds is default risk. This refers to the possibility that the issuer of the bond or loan may be unable to meet its interest payments and/or repay the principal amount. This can become a real possibility during times of economic stress. The value of these investments can fluctuate dramatically based on a range of factors, including market sentiment, company-specific news, or broader economic deterioration. For example, if a company issuing high yield bonds reports poor earnings or faces operational challenges, the value of its bonds may drop. Similarly, changes in interest rates or economic downturns can lead to sharp declines in the value of high yield credit investments. This volatility means that while you might experience higher returns during periods of economic growth, there's a substantial risk of seeing your investment value decline during downturns or periods of market uncertainty.

As with Olympic contenders, where unexpected outcomes can shift the podium positions, in the investment arena, a single default can have significant repercussions. The risk is magnified in high yield credit funds, where issuers are often less stable and more susceptible to economic fluctuations. Just as a single misstep in a crucial race can cost an athlete the gold, a default can lead to substantial losses for investors.

Transparency Risk: The price of potential high returns

Valuation is a key piece of private credit, affecting returns, risk, the cost and availability of capital. Since valuations are typically periodic with long lags, they may not reflect current market conditions or asset performance. This issue can be worsened where a fund may not fully account for borrower difficulties in its valuations. Inflated valuations can reduce loan liquidity, as there's less incentive to redeem at true values. Unfortunately, this trend is becoming more common across the private credit industry.

Property Construction Loans: additional risks

Property construction loans, a subset of private credit funds, come with their own set of risks that can amplify the overall risk profile of high yield credit funds. These loans are typically provided to developers for building residential or commercial properties and are often characterised by high interest rates due to the inherent risks involved.

Construction projects can face numerous challenges in tighter times, such as delays, cost overruns, and regulatory hurdles. If a project encounters significant problems or fails to complete on time, the borrower may struggle to repay the loan, increasing the risk of default. The financial health and track record of the developer is critical in assessing the risk of default. Such loans can also be less liquid compared to other investments. If you need to exit your investment before the construction project is completed or the loan matures, you might face difficulties in finding a buyer or could have to sell at a discount.

Balancing Risks and Rewards

Investing in high yield credit funds and property construction loans can be a way to achieve higher returns, but it's important to weigh these rewards against the associated risks. Credit investments can offer attractive income opportunities, but they come with the potential for significant volatility and default risk. Property construction loans add another layer of risk.

To navigate these risks, a diversified investment approach can help. Balancing high yield credit funds with more stable investments, such as government bonds or investment grade securities, can provide a buffer against the volatility and risk of high yield investments. Additionally, thorough due diligence on the underlying assets and careful consideration of the economic environment can aid in making informed investment decisions.

Ultimately, the quality of private credit depends on the investment managers behind it. Their expertise in assessing and monitoring loans, managing risk, and protecting capital is key. Additionally, their experience, industry relationships and track record across various market cycles are essential factors.

Government Bonds: A safe haven in a volatile environment

Government bonds typically perform well during periods of economic uncertainty and downturns. With sustained inflation and higher interest rates, the real return on existing bonds can become less attractive compared to new issues, which might offer higher yields. However, government bonds retain their appeal due to their stability and lower risk profile. And, within a government bond fund, portfolios are diversified with individual bonds maturing being steadily replaced by newer issues, which helps these funds keep pace with return needs.

Government bonds inherent safety can attract investors looking for a refuge amid economic volatility. When interest rates eventually start to decline, the value of existing government bonds with higher coupon rates is likely to rise. Lower rates mean that newly issued bonds will offer lower yields, making existing bonds with higher rates more valuable. Additionally, as the economy begins to recover and inflation pressures ease, government bonds will likely benefit from renewed investor confidence and demand.

Navigating Higher Risk in a Challenging Environment

Credit funds react differently to the economic landscape. In the current environment of high inflation and interest rates, the risk of default among companies with weaker credit ratings increases. As interest rates start to decline, the situation for high yield credit funds may improve, but not without complexities. Lower rates can reduce the cost of borrowing for companies, potentially easing some of the financial pressure and reducing default risk. However, the recovery in high yield credit markets might be uneven, depending on how quickly economic conditions improve and the specific financial health of the issuing companies.

In light of these dynamics, it's crucial for investors to consider how shifts in economic conditions could impact their portfolios. Government bonds may offer increased value as interest rates decline, while high yield credit funds might see some relief if economic conditions improve.

For a balanced investment approach, incorporating government bonds can provide stability and potential capital appreciation in a declining interest rate environment. Meanwhile, carefully selected high yield credit investments might still offer opportunities for higher returns, but should be approached with caution and a clear understanding of the associated risks.

Which Investment Takes Gold?

So, where does that leave investors? High yield credit funds and government bonds each play distinct roles in an investment portfolio, much like different events on the track. High yield funds are akin to the high-risk, high-reward sports, where taking on greater risk can lead to the potential for impressive returns, much like a daring pole vault or a thrilling sprint. These funds might suit investors prepared to handle the volatility and aim for those high yield medals.

On the other hand, government bonds are like the marathon--steadily paced and reliable. For investors seeking stability and a steady income, government bonds are your marathon runners, providing a dependable performance over time. They are well-suited for investors who value consistency and want to avoid the unpredictability of higher risk investments.

Ultimately, the choice should align with an investors financial goals, risk tolerance, and how they view the economic landscape unfolding.