What’s The Difference Between Momentum And Trend Following?

At the end of 2019, Two Sigma’s Venn platform added three new macro style factors to its risk model, the Two Sigma Factor Lens: Fixed Income Carry, Foreign Exchange Carry, and Trend Following. The first two factors are meant to capture an investment’s or portfolio’s exposure to carry strategies: i.e., holding higher-yielding bonds or currencies funded by their lower-yielding counterparts. Trend Following is meant to capture momentum, using the trailing returns of macro asset classes.

The latter sounds a lot like the Momentum equity style factor, which already exists in the Two Sigma Factor Lens. In fact, the two have a positive long-term correlation of 0.3. How are these two factors different, and why does it matter?

DIFFERENCE #1: THE UNDERLYING ASSET CLASSES

The first, most obvious difference between the two is the asset classes used to construct each factor. Momentum is an equity style factor that is built using individual stocks — so it could be long Apple and short Alphabet, as an example. Trend Following is a macro style factor and is therefore built using derivatives (e.g., futures and forwards) in several macro asset classes: equities, fixed income, currencies, and commodities — so it could be long an S&P 500 Index futures contract and short a gold futures contract for example.

DIFFERENCE #2: CROSS-SECTIONAL VS. TIME SERIES MOMENTUM

The second, and arguably the most important, difference between the two factors is the type of momentum that they are capturing. The Momentum equity style factor is constructed cross-sectionally, meaning an asset’s momentum is compared to the momentum of other assets. Trend Following, on the other hand, is constructed using time series momentum, which focuses purely on an asset’s own past returns.1

This has an important implication: the Momentum factor will be market neutral to global equity markets at all times, while the Trend Following factor can take on conditional (positive or negative) correlation in any of the four asset classes mentioned above, but it should not demonstrate meaningful correlation to those asset classes over a full market cycle.2

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Disclosure: This article is not an endorsement by Two Sigma Investor Solutions, LP or any of its affiliates (collectively, “Two Sigma”) of the topics discussed.The views expressed above ...

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