As we all know, AI is everywhere these days. Even my soon-to-be 82-year-old father spends a considerable amount of time learning and researching topics on the AI platform to which he subscribes. He recently called and informed me that he needs to increase his allocation to trend following because AI told him so. Even though I’ve been managing trend following strategies for more than 2o years, AI is the expert. I decided to investigate further for myself.
I asked AI “how much exposure should an investor have to trend following in their portfolio?” I was informed that “with a 0.4–0.6 Sharpe and near-zero correlation to stocks and bonds, mean-variance spits out 25–40%” allocation. Yet AI went on to state that a 25%-40% size allocation is likely too high as trend following went through a decade (2009-2019) in which it delivered little in the way of return while equities compounded. There was no mention of the most recent decade (2000-2010) when US equities delivered negative returns.
AI recommended funding a trend following allocation out of one’s bond allocation especially in an inflationary environment. As to the funding source “out of bonds is the strongest case post-2022: similar defensive intent, better behavior when the drawdown is inflationary rather than deflationary, higher expected return.” I would tend to agree, especially if we are in fact in a new paradigm of rising interest rates and persistent inflation. Historically, commodities have been by far the best performing asset class in such environments while bonds struggle to produce a real return.
In addition, AI built an interactive dashboard allowing me to optimize the trend following allocation in relation to the portfolio Sharpe ratio. According to AI “The plateau is the actual takeaway. Under most reasonable input sets (see allocation, trend Sharpe, trend volatility and correlation to equities in the table below) the curve is nearly flat from roughly 10% to 30%, which means precision in the sizing decision earns you very little.” What is crystal clear is the additive value a trend following allocation brings to a traditional investment portfolio. Nearly all investors are underinvested, particularly at the point in the economic cycle, and relative to the paradigm shift we’re seeing with inflation and interest rates.
Finally, AI went on to reiind me of the advantageous tax treatment of futures in a taxable account. “One thing worth weighting more heavily than most allocators do: in a taxable account, futures get 60/40 long/short-term treatment with annual mark-to-market. That’s a meaningfully better after-tax profile than most alternatives generating the same gross return, and it can justify sizing at the higher end of the range for taxable investors specifically.”Another advantage for trend following strategies is the fact that a large component of the fund’s capital sits in cash equivalents earning a treasury bill or similar rate due to the embedded leverage in futures contracts. As rates rise, these strategies capture rising short-term yields while generating trading profits on top. As such, the strategies are highly efficient from a capital perspective.
Bottom Line: Don’t take my word for it, ask AI.