By and large, emerging markets have been uncomfortable places for investors in recent quarters. However, EM equities have had a run of strength in recent weeks, and this has pushed them into positive territory on a number of trend-following measures, including several that are included in the Market Compass composite trend measures.
Traditional trend-following approaches have had a challenging time in emerging markets since the financial crisis. As we can see in Figure 1, returns have basically been flat for the last four years, as occasional uptrend have reversed, leading to unprofitable “whipsaws.”
FIgure 1. Emerging Markets: Simple Moving Average System vs. Buy-and-Hold
Data source: Yahoo! Finance
The illustration above uses data from the Vanguard emerging markets index mutual fund and a very simple trend-following approach: if the unit value of the fund finishes the week above the average for the last 45 weeks, the system “goes long” or buys into the market. If the emerging markets fund’s price is below the 45 week average, the moving average system takes a position in Vanguard’s short term bond fund.
This simple system does outperform a buy-and-hold approach, and with visibly less volatility. However, the question could be asked of whether this is a reflection of the starting and end dates chosen. If an investor had tried to apply this simple trend-following approach, starting on different dates, would the results still be favorable?
We can answer this by running a simulation that uses randomly-selected start- and end-dates. We have 900 weeks of data below, so we set up a test that allows the investor to start at any point in the first half of the data-set, and to finish any time in the second half. With 1000 random start- and endpoints, we get the following results for return (annualized) and risk (as measured by annualized standard deviation):
Figure 2. Simulation Outputs: Return and Standard Deviation, by Percentile
Source: Yahoo! FInance data, 1000 simulations using Yasai Excel add-in
The simulation outputs show results for the simple trend following approach (the Moving Average results) versus a buy-and-hold for randomly chosen start- and end-dates, in percentile groups. In other words, the “5th” columns show the results for the periods that deliver the lowest 5% results; conversely, the “95th” shows results at the top end. As we can see, the moving average system delivers better returns across all percentiles, with consistently much lower standard deviation.
The Market Compass models do not use trend-following measures on their own, and we have looked in other posts at the role of other factors such as macroeconomic conditions and valuations, but this example highlights that they can offer the potential of higher returns and lower risk when compared to a simple buy-and-hold. As we have seen, even in the case of a market that is tending downwards, such as the Japanese equity market over recent decade, simple trend-following approaches can add value and reduce risk.
The outputs of the Market Compass models are available as always at the usual place.
Have a good week!