Why AQR Thinks Trend Following Will Continue to Outperform

Investors are “anchored to a low inflation, low interest rate regime,” which may benefit trend followers, according to AQR’s Jordan Brooks.

Illustration by II

Illustration by II

AQR expects trend-following strategies to continue to thrive amid ongoing macro uncertainty.

Although trend following experienced a moderate pullback in the first four months of 2023 — losing an average of 2.4 percent — AQR believes the strategies will outperform the market during the remainder of the year as macroeconomic volatility remains elevated, according to the asset manager’s latest research paper. Trend-following strategies had a strong run in 2022, returning an average of 14.5 percent while the S&P 500 lost nearly 20 percent, according to the HFRI 500 Trend Following Directional Index.

“What a trend following strategy is attempting to capitalize on is the systematic tendency of new information to have a persistent effect on asset prices,” Jordan Brooks, co-head of the macro strategies group at AQR, told Institutional Investor. “The more macroeconomic shocks that hit markets, and the larger their magnitude, the more under-reaction you will tend to see.”

According to the paper, macro uncertainty tends to be highly persistent, meaning a month of high volatility will likely be followed by another one. Trend followers often benefit from the market’s slow reaction to continued macroeconomic shocks.

Take last year, for example. “You saw a massive amount of under-reaction in 2022,” Brooks said. “Nobody was fully updating their expectations to inflation. There were 19 months between the beginning of 2021 and August 2022 where inflation forecasts were revised upward…And I think that’s why trend-following strategies did extraordinarily well.”

Brooks said he has spotted a similar pattern in 2023. He believes most investors are “anchored to a low inflation, low interest rate regime” after seeing the market rebound in the first quarter. But the Federal Reserve will be a lot more hawkish than what markets have priced in, he added.

“The current backdrop is one of aggressive tightening of monetary policy, central banks likely to face a trade-off between unemployment and inflation, and an exceptional degree of disagreement between what markets are pricing in and what the Fed and economists are forecasting,” Brooks said. “I think all these things are catalysts for elevated uncertainty in the future.”

According to Brooks, the traditional price trend model can be enhanced by incorporating economic trends. A recent AQR paper shows that a hypothetical economic trend model, which considers how macro factors like GDP and inflation have been affecting the markets, has generated consistent positive performance over time and across different asset classes.

“While economic trend is a close relative of price trend-following — both approaches aim to capitalize on the tendency of markets to systematically under-react to news—the two strategies are highly complementary,” according to the paper. “Combining the two leads to improved risk-adjusted performance and more robust drawdown protection than price trend-following alone.”