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Everything to Know About Trend Following Funds

Profiting from the market’s general ups and downs is the goal of the trend following strategy. Recognizing and acting in accordance with established patterns is key to this approach, whether those trends point upward, suggesting bullish markets, or downward, indicating bearish markets.

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Trend following funds 101

What are trend following funds?

The term “trend following funds” is used to describe investment strategies that aim to profit from market trends of varying durations and conditions. These investments use computational algorithms and other systematic approaches to identify market price patterns. They believe that bullish markets will likely continue their ascent and negative markets will likely continue their decline.

Mutual funds, managed accounts, UCITS, and ’40Act (Mutual Fund) structures are just some of the different types of trend-following funds available. Diversified market exposure is provided by these funds, which can invest in stocks, bonds, ETFs, futures, actual commodities, cryptocurrencies, and interest rates, among many other things.

When added to a larger investing portfolio, especially one that consists of traditional equities and bonds, trend-following mutual funds can be a useful diversifier.

Strategies based on identifying and acting on trends involve going long on rising markets and short on falling ones. These methods use proxies for trends’ durations derived from the underlying assets’ prices and volatility.

Most CTAs use trend-following tactics, which involve the use of various quantitative models to determine if and when a trend has become established in a given market. They then use the model’s output to guide their investing decisions.

Within trend-following methods, systematic trading and discretionary trading are the two main ways. The hallmarks of systematic trading are the use of predetermined risk tolerances, rules for when to enter and leave trades, and other forms of automated execution.

In contrast to the strict criteria used in systematic trading, discretionary trading depends on more flexible guidelines. Discretionary traders need to be flexible, which necessitates paying closer attention and making more analytical decisions when the strategy is implemented.

Both rising and falling markets present opportunities for trend-following funds. They display convexity, or a non-linear pay-off structure with respect to their underlying market universe. Investors who value diversification greatly value this trait.

Numerous skilled institutional investors across the globe have a strong history of investing in trend-following methods. The key justification for this decision is the diversification they provide, which is especially useful when used to supplement more conventional investments like stock and bond portfolios.

trend following funds meaning
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Trend following indicators, rules and strategies

Traders and investors employ trend following indicators, rules, and methods to spot and profit from upward (bullish) and downward (bearish) market trends, respectively. These resources and strategies are designed to help traders recognize and capitalize on trends in a systematic, rule-based manner.

Indicators, guidelines, and tactics for trend tracking that are frequently employed include the following:

Trend Following Indicators

One of the most well-known trend-following indicators is the moving average, which comes in both simple and exponential forms. Crossovers between shorter and longer term moving averages are frequently used by traders to spot emerging trends. When the shorter moving average rises above the longer one, it’s considered a bullish crossing, and when it falls below, it’s considered a bearish one.

Moving Average Convergence Divergence (MACD) is a momentum oscillator that employs two moving averages to assess trend strength and direction. Signals to buy or sell are generated when the convergence or divergence of the two moving averages meets certain criteria.

The Average Directional Index (ADX) is a trend strength indicator. When the ADX goes up, it shows that the trend is getting stronger, but when it goes down, it suggests that the trend is getting weaker. Many investors use the ADX alongside the directional movement indices to verify a trend’s strength or weakness.

The RSI, or Relative Strength Index, is an indicator of the rate of change in prices. Overbought/oversold levels are monitored for potential reversals in trend.

Support and resistance levels, the direction of the trend, and the rate of momentum may all be gleaned from the Ichimoku Cloud, which brings us to our fifth and last indication. Price action above the cloud is seen as optimistic by traders, while price action below the cloud is seen as bearish.

Trend Following Rules

One of the cornerstones of trend following is to ride the wave of price movement. In other words, you should buy into a bullish trend and sell into a bearish trend.

Risk management is an essential component of trend following. Stop-loss orders are frequently used by traders as a means of preventing large losses. Stop-loss orders are executed to reduce losses when prices move counter to the trend.

Rule-based position sizing aids in risk management. Traders set the size of their positions according to their appetite for risk and their available capital. Losses can be contained by the use of proper position sizing.

Trend followers utilize several indicators and criteria to determine when to enter and leave a trade. A popular entrance signal is a crossover of two moving averages, while a crossover in the opposite direction can serve as an exit signal.

Always keeping an eye on your positions and the market, as trend following is a continual activity. As markets shift, traders readjust their holdings accordingly.

Trend Following Strategies

We have the Moving Average Crossover, a straightforward method for generating buy and sell signals based on the intersection of two moving averages.

The second type of trading is known as “breakout trading,” and it involves getting into trades when the price either breaks through key support (bullish entry) or resistance (bearish entrance).

The Donchian Channel Breakout Strategy utilizes Donchian Channels to pinpoint possible entry and exit locations as prices break out of predetermined ranges.

Managed futures and hedge funds frequently use diversified trend-following strategies across various asset classes, which brings us to our fourth type of trend-following fund: the diversified trend-following fund. These funds give investors access to these tactics.

Trading against the trend, or counter-trend, is a technique that seeks to make money during market downturns rather than rising prices. In order to forecast when a trend might change direction, traders employ oscillators and other indicators.

Time series momentum evaluates the strength and persistence of price movement over various look-back periods before entering positions.

Both day traders and long-term investors employ trend-following indicators, rules, and tactics to play along with market trends and potentially profit from price fluctuations. One’s trading personality, level of risk appetite, and current market conditions should all be taken into account while deciding on indicators and techniques.

It’s crucial to undertake rigorous testing and back-testing before using any specific method and to integrate risk management into the trading technique. Market circumstances can fluctuate, and past performance is no guarantee of future success.

pros and cons of trend following funds
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What are the advantages and disadvantages of trend following funds?

Pros of Trend Following Funds

  • New market trends with significant momentum can be spotted early with the use of trend tracking tactics. Traders can use this method to profit from most, if not all, developing significant trends.
  • The entry and exit positions in trend following methods do not need to be as precisely calculated. Traders who don’t have the resources to keep an eye on the markets around the clock can benefit from this versatility.
  • The transaction costs associated with these tactics are often lower than those associated with more aggressive trading approaches. By not having to trade as often, trend followers can save money on brokerage fees and other transaction costs.
  • Trend following tactics allow traders to ride trends for extended periods of time. This method’s main benefit is that it can detect long-term tendencies.
  • Financial portfolios can benefit greatly from the addition of trend-following tactics as a means of diversification. They provide a different approach to investing than stocks and bonds, which can increase the portfolio’s total diversification.
  • Traders and investors who want to take advantage of market trends and diversify their portfolios may find trend following tactics appealing because of these advantages.

Disadvantages of Trend Following Funds

Although there are benefits to using a trend following approach, there are also drawbacks to consider. Some potential downsides of trend following tactics are as follows:

  • Trend following tactics may face false breakouts, where an anticipated trend does not materialize or swiftly reverses, leading to losses. Traders may find this to be annoying.
  • Periods of diminishing portfolio value, known as drawdowns, can be a difficult component of trend following. Traders’ mental and financial fortitude may be tested during extended drawdowns.
  • Delays in reacting to shifts in the market may be an issue for trend-following methods that rely on lagging indications. Traders may miss out on chances or respond too slowly to reversals due to the delay.
  • Like any other trading method, trend following may not always yield positive results. Due to its sensitivity to market conditions, it may underperform or even result in losses during periods of range or turbulent markets.
  • Discipline is needed for successful trend following, as is a predetermined set of norms to which all participants must conform. Some traders may find it difficult to keep their emotions and impulsive tendencies in check and follow this technique to the letter.

How trend following funds perform during market downturns

trend following funds performance
Photo by Dovis

The topic of how trend-following funds do in bear markets is complex. For risk management, they are highly recommended due to their proven ability to withstand market downturns. The potential for these techniques to prosper during prolonged equity market duress is further increased by the fact that they frequently demonstrate a negative downside correlation to equity markets.

Trend following’s distinguishing advantage resides in its capacity to profit in both rising and declining markets, creating doors for big gains. However, this resilience might erode in the face of volatile markets, increasing the risk of financial loss. Consistent drawdowns, or periods of continuous decrease, can also be difficult and put traders’ financial and emotional resources to the test.

When projected trends fail to materialize, trend followers run the danger of suffering significant losses due to false breakouts. Further, as trend following uses lagging indications, it may be slow to react to market shifts, resulting in lost opportunities.

Trend following ETF

Exchange-traded funds (ETFs) that follow trends try to duplicate the results of that investment strategy. These ETFs are designed to mimic the performance of an underlying index or portfolio of assets that uses trend-following strategies to profit from both rising and falling markets.

Trading choices in these approaches are frequently made with the use of quantitative models and algorithms.

  • Trend-following ETFs use a methodical, market-trend-based investment strategy. They typically target directional or momentum price changes in stocks, bonds, commodities, and currencies to generate gains.
  • Many ETFs that track trends invest in a wide variety of assets, providing diversification for traders. This spreads out your risk, making you less susceptible to the ups and downs of a particular market or collection of assets.
  • ETFs’ high liquidity is a well-known feature because they are traded on stock exchanges much like regular equities. The ability to buy and sell shares throughout the trading day is made possible by the market’s liquidity.
  • Investors in trend-following ETFs may rest certain that their money is being handled by seasoned professionals who are experts in putting the approach into action.
  • ETFs are open about their holdings and investment philosophy. In order to familiarize themselves with the ETF’s investment strategy and underlying assets, potential buyers might consult the product’s prospectus and performance history.
  • Trend-following methods are built to spread your money around and hopefully make you money in both up and down markets. They are not, however, risk-free, and can suffer drawdowns during periods of range-bound or whipsaw market action.
  • Similar to traditional ETFs, trend-following ETFs charge an annual management fee. Investors should think about the expense ratio while deciding whether or not to put money into these funds.

Trend-following ETFs track indices or trade systematically. These ETFs aim to expose investors to commodities, currencies, or a diverse portfolio. Review the fund’s prospectus, past performance, and underlying assets to see if it matches your investing goals and risk tolerance when choosing a trend following ETF.

Trend following mutual funds

The goal of trend-following mutual funds is to make money regardless of the direction the market is trending in, whether that’s up or down. To spot and capitalize on market trends in stocks, bonds, commodities, and currencies, these mutual funds frequently employ quantitative methods and rules-based methodologies. Although mutual funds aren’t as typically linked with trend following tactics, there are a few that do use some of the same tenets as ETFs and hedge funds.

Mutual funds and UCITS, two types of registered vehicles, offer access to a number of trend-following mutual funds. Such arrangements typically feature competitive pricing and extensive reporting down to the position level. Investors who want to gain exposure to trend following tactics but lack the knowledge or means to implement them on their own may find trend following mutual funds to be a suitable alternative.

Diversification from standard stock market and bond holdings is just one of the many benefits that trend-following mutual funds may provide. They have a non-linear payoff to their underlying market universe and can be profitable in both rising and falling markets. Trend following mutual funds can also have certain downsides, such as false breakouts, drawdowns, and reliance on lagging indications.

Is there a minimum to invest in trend following funds?

The minimum investment for trend following funds might vary depending on the fund and the investment structure. Investment minimums for various funds might range from $5,000 to $1 million or more.

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