How Trend Following Strategies Can Reduce Risk In Your Passive Portfolio

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Investing is all about risk versus reward. And for passive index investors, this often comes down to asset allocation. By tweaking your exposure between equity, fixed income and alternative asset classes, you can trade in some potential upside for reduced volatility. But risk management doesn’t have to end there!

So in this article, I want to take a closer look at so-called passive index investing. And as you’ll see, these strategies aren’t quite as hands-off as you might think. This understanding will open the door for us to explore some other simple portfolio management strategies that might present alternative ways to reduce risk at a low cost.

To get started though, let’s quickly recap some of the biggest pros of buy-and-hold index investing.

The Rise Of Passive Investing

Unless you’ve been living in a cave for the last decade, the rise of index investing shouldn’t come as a surprise to you. And if you think about it, it really makes sense!

After all, the data is pretty clear that most actively managed funds can’t beat their benchmark in any kind of lasting or statistically significant way. For example, the Financial Times recently reported that since 2006, 99% of actively managed funds have underperformed.

And to make matters worse, even if you do find an outperformer, high mutual fund fees quickly erode your realized returns (especially when compounded over decades).

So with these factors in mind, it’s no surprise that investors are voting with their money, and moving to index funds. After all, if you can’t beat ‘em, why not join ‘em, right?

And the proof is in the fund flows. Vanguard, the poster-child for low-cost, ETF-based indexing has ballooned. In fact, over the last 7 years, assets at this low-cost fund company have grown from $1 trillion to $4.2 trillion (source). If that’s not a compelling testimonial for index investing, I don’t know what is!

But although the rise of passive-index investing is extremely compelling, and has no doubt helped everyday investors keep more money in their pockets, is it really passive?

Redefining Passive Index Investments

In my experience speaking with investors over the years, I’ve found that most people who consider themselves passive investors are indexers. And I know that probably doesn’t come as a surprise to you. You might even fit in this category yourself!

If not, here’s how it works. You buy a select number of broad-market ETFs every time a paycheck comes around. You plan to hold onto your investments until retirement. And other than the occasional rebalance to get back to your target asset allocation, you don’t do a ton of trading. Sound familiar?

Well, from the investor’s perspective, this approach is most certainly passive in nature. But it’s worth asking yourself, what’s going on under the surface? Because the truth is, while indexing is low cost, and has a great long-term track record, it’s not totally passive!

In fact if you think about it, indexes are regularly adding and removing companies each quarter! Of course there’s a well-defined and mechanical methodology for rebalancing the underlying index. But all this activity within the ETFs themselves isn’t exactly passive.

Plus, if you consider smart beta ETFs as part of your portfolio, the turnover within your funds is likely even higher. While still low-cost, these funds use simple rules that help you gain different factors of market exposure, such as momentum, value and volatility. And for our discussion today, it’s the former that I’m most interested in.

In particular, simple trend following trading strategies can help you manage market exposure across asset classes. And a basic momentum factor like this is very simple for even the lowest-touch self-directed investors. Plus, the risk management these strategies offer might even help you sleep better at night!

Trend Following, Crisis Alpha And A Good Night’s Sleep

Trend following trading strategies are pretty simple. But they’re a little bit counterintuitive, especially to anyone who likes to buy low. But what you give up in perceived value, you make up for in downside protection. That’s because when markets start selling off, trend followers get out too.

And further, if you apply trend following strategies to a variety of asset classes, studies show you can actually achieve crisis alpha, allowing you to outperform in down markets. This  can be a very effective way to further reduce your risk. The benefits don’t stop there though.

In an article last year, Ritholtz Wealth Management Direct of Research Michael Batnick explained he has 15% of his assets in their tactical asset allocation model. The reason is, during a vicious bear market like what we saw in 2008, it can be really tough to stick to your buy-and-hold strategy if your whole portfolio is on the line.

For example, if you’re facing a 40% drawdown on your entire net worth, can you be sure you won’t bail out at the worst possible time? Whereas, at least if you have some cash on the sidelines it might be psychologically easier to keep your main nut invested, despite the pain of big unrealized losses. Make sense?

It’s hard to put a price tag on what this peace-of-mind is worth, but it’s a great way to reduce any investing stress and sleep soundly. Additionally, the consequences of selling out at the bottom of a bear market can be devastatingly difficult to recover from. Of course the key is to have your tactical rules in place before you need them.

And since tactical trend following uses a rules-based approach, I thought it might be of interest to everyday index investors who are already using mechanical models to grow their net worth. Remember, the S&P is basically a simple trading strategy with defined rules. So for me, the question is, can you build a better index with your portfolio?

Keep in mind, when you consider risk, reward, liquidity and volatility, “better” might look different for each of us. But let me show you how I do it.

How I Apply Trend Following Strategies In My Stock Portfolio

By reflecting on my own psychological loss tolerance, investing time-frame and asset allocation, I’ve added some trend following strategies to my self-directed investing account. Now personally, I apply these ideas to both individual stocks and ETFs. But the concepts can work for any asset class.

So in case you’re curious, here are some tips that have helped me:

#1. Don’t overdo it. Even though online discount brokers make it cheap to trade, there are still costs to every transaction. Plus, every time you act you create an opportunity to make a mistake. That’s why I use longer-term trend following models to help me allocate my portfolio. For example, maybe you reduce your exposure to an asset class when the ETF you’re tracking closes below the 200-day moving average.

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Most of the time this trading signal only happens once or twice a year. But if you were to use a short term trigger (such as selling out at a 20-day low) you’ll be jumping in and out of the market way too much, which can be expensive, error prone and time-consuming.

#2. Create trend following rules ahead of time. The famous trader Paul Tudor Jones said he never bought assets below their 200-day moving average. This may be appropriate for you or not. But whatever rules you decide on, they should be clearly defined ahead of time. Because if you wait until the heat of the moment when the market starts to panic, you’re more likely to make an expensive mistake.

#3. Think of trend following as tactical rebalancing. Some index investors are strictly against any kind of discretionary trading or stock picking. So instead, think of this as another type of rebalancing. Research shows momentum factors tend to persist. And by rebalancing away from underperforming assets, you may be able to make your money work harder for you. At the same time, you’re less likely to tie up your cash in languishing funds or stocks.

#4. Consider your overall investment plan. Depending on your overall asset allocation, risk tolerance, tax jurisdiction and investing time frame, this kind of strategy might not make sense for you. On the other hand, if you’re nearing retirement and want to preserve your wealth without giving up equity exposure altogether, trend following can be a great way to manage risk while still participating in upside.

But at the end of the day, investing decisions are intensely personal so spend some time thinking about how momentum strategies could apply to you.

#5. Forget buying low. This is often very counterintuitive for many value-focused investors. But as the saying goes: cheap things are cheap for a reason! And if you believe markets are mostly efficient, then why would you fight a downtrend and risk tying up money in an underperforming issue for months, quarters or even years on end?

On the flip side, trend following trading models often result in paying a little bit more for a given security. But by buying when momentum is on your side, you could be reducing uncertainty that your ETF will underperform.

Of course I hope this list of momentum investing tips is enough to whet your appetite. But I know you’re probably looking for a little more information on this approach to markets. So here are some of my favorite materials.

Next Steps For Trend Following In Stocks And ETFs

If you think trend following strategies might be an interesting addition to part of your portfolio, then I highly encourage you to do some further reading. There are tons of great resources available online and in print that can help you apply these ideas to your own investing (even if you prefer a more passive approach).

Here are some potential next steps:

Trend Following by Michael Covel – The definitive book on the topic of trend following, and the recently released new edition has some great updates you won’t want to miss. Although this book talks about trend following in the purest sense, the underlying theory and examples are invaluable for everyday investors.

Finding Trend Following Stocks with FinViz – This detailed article explains how I try to look for fundamentally sound momentum stock picks and ETFs using free stock screening tools available online. This should be a relatively easy next step for anyone managing their own portfolio.

Momentum Factor WhitePaper – Learn a little more about the theory behind trend following and how the momentum factor can be applied to index investing. Even if you don’t actively trend follow, these indexes may be another way to apply the strategy to a portion of your portfolio in a low-cost and low-touch way.

While I know trend following strategies aren’t for everyone, I hope this article has helped you think in a new direction in terms of how to enhance the risk-to-reward profile of your index investments.

Author Bio: Jay Delaworth is an experienced trader, who specializes in blending fundamental analysis with technical trend following strategies to find actionable trading ideas. Visit IntelligentTrendFollower.com, where Jay publishes new breakout stock picks each weekend.