Beyond its primary role of reducing drawdowns, trend following acts as a premier diversifier that can solve several portfolio construction flaws at once. It can dynamically allocate to foreign markets (solving home bias), value stocks (when they're trending), and real assets like gold and silver, providing exposure that traditional portfolios often neglect.
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Instead of simply owning different stocks and bonds, a more robust strategy is to hold assets that perform differently under various economic conditions like high risk, instability, or inflation. This involves balancing high-volatility assets with stores of value like gold to protect against an unpredictable future.
A basic trend-following system for gold—buying only when it reaches a new all-time high and selling after a modest pullback—historically outperforms a passive buy-and-hold approach. This counterintuitive finding suggests that for certain volatile assets, systematic momentum strategies can be more effective than passive ownership, capturing upside while managing downside risk.
A portfolio's performance can be dramatically enhanced by combining traditionally separate strategies. A leveraged mix of equities (S&P), hedges (long volatility), and trend-following strategies can produce returns that are multiples higher (e.g., 40x) than equities alone (e.g., 6-7x) over the same period.
Owning multiple stocks or ETFs does not create a genuinely diversified portfolio. True diversification involves owning assets that react differently to various economic conditions like inflation, recession, and liquidity shifts. This means spreading capital across productive equities, real assets, commodities, hard money like gold, and one's own earning power.
The most profitable periods for trend following occur when market trends extend far beyond what seems rational or fundamentally justified. The strategy is designed to stay disciplined as prices move to levels few can imagine, long after others have exited.
A more robust diversification strategy involves spreading exposure across assets that behave differently under various macroeconomic environments like inflation, deflation, growth, and contraction. This provides better protection against uncertainty than simply mixing asset classes.
Contrary to common belief, substituting the bond allocation in a traditional 60/40 portfolio with gold has historically resulted in remarkably similar overall returns. This finding challenges the conventional wisdom that bonds are the only viable diversifier for equities and suggests gold can fulfill a similar portfolio-stabilizing function over the long term.
Combining managed futures with equities in a single product makes the strategy easier for investors to hold behaviorally. However, this “smoother ride” comes at a cost: it dilutes the powerful, anti-correlated impact that a pure-play managed futures strategy can have during a significant market downturn.
Market cap indexing acts like a basic trend-following system by buying more of what's rising. However, its Achilles' heel is the lack of a valuation anchor, causing investors to over-concentrate in expensive assets at market peaks. In high-valuation environments, almost any other weighting method, like equal-weight or value, is likely to outperform over the long term.
Investors hesitant to buy assets like gold near all-time highs can use trend following for exposure. The strategy systematically enters prevailing trends and, crucially, provides a built-in, non-emotional exit signal when the trend reverses, mitigating timing risk.