The investment universe consists of 125 US stocks. This universe is screened to form a portfolio of 20 stocks that are trading above their 200 day moving average. If a stock falls below its 200 day moving average, it is replaced with another stock that is above its 200 day moving average. An active risk management system will adjust the amount of cash in the portfolio based on market sentiment. If a large percentage of stocks in the market is trending down, the strategy will increase cash allocation to protect the portfolio.
Trend following works because trends tend to persist. Stocks that are going down tend to continue going down while stocks that are going up tend to continue going up. It is not about buying high and selling low but rather buying when the price starts rising and selling when the price starts falling. The advantage of trend following is that the strategy sells early in a bear market and then buys when prices start to recover. When there are big trends in the market, trend following can produce outstanding returns.
The active risk management system will protect the portfolio from large drawdowns by raising cash when markets are trending down. When markets are recovering, the strategy will reduce cash allocation and remain invested to take advantage of rising prices.
The backtest results show that the strategy significantly outperforms the S&P 500 with an annual return of 13.7% vs 8.7%. The strategy also does a great job in terms of risk management having a lower volatility of 13.5% vs the S&P 500 (20.3%). The strategy's max drawdown, which is the maximum capital loss from its peak is -21.3% during the 2008 financial crisis vs the S&P 500 which lost 55.2%.
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