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One important top-down investment asset allocation decision investors must make is how to allocate money between low-risk government bonds and higher-risk portfolios of stocks and other investments. While the latter offer the expectation of higher return, a benefit of the former is not only their lower expected risk but also their attractive diversification properties in crisis situations. Connolly, Stivers, and Sun (2009), for example, showed that the correlation of bond returns with stock returns tends to be low in times of market turbulence. While investments in bonds offer low risk and equities offer high returns, the temptation to capture both gives rise to systematic directional trading that exploits the best of two worlds by following trends in equities, bonds, and other asset classes, typically through the use of futures contracts.
Directional trading, as a component of an investor portfolio, is often entrusted to commodity trading advisors (CTAs) or macro funds, which implement futures trading strategies on market trends. This trend-following behavior lends support to Samuelson’s dictum (see Jung and Shiller 2005) that the stock market is “macro inefficient,” relating the investigation of CTA performance to the efficient market hypothesis (EMH). Research in the field by Cutler, Poterba, and Summers (1991); Szakmary et al. (2012); Moskowitz, Ooi, and Pedersen (2012); and DeMiguel, Nogales, and Uppal (2014) supports macro inefficency by presenting evidence of the positive time-series predictability of a security’s own past returns, the “trend” effect, backing the credibility of trend followers. If this trend effect exists, a successful trend follower may be profitable in both bearish and bullish markets, but may also deliver equity-like returns.
Unfortunately, the problem with trend-following strategies is that their performance and simultaneous exposure to different market trends can be difficult to assess in the long run. The existing conception of the characteristics of trend followers is that they aim to follow market trends by following both bullish and bearish market trends to profit from large positive and negative price movements. However, the existing literature makes no clear distinction between the actual trading of the two different market trends. Fung and Hsieh (2001) modeled the returns of trend followers using lookback straddles. Moskowitz, Ooi, and Pedersen (2012) documented the trend effect, which takes into consideration both the long and short positions...